This is a simple, straightforward approach to Roth IRA basics – use it to get started, today! We begin with some essentials and outline how Roth IRAs work. Keep this handy as you work on your Family’s finances!
Understanding Roth IRA Basics and Essentials. What is it?
Table of Contents
- 1 Understanding Roth IRA Basics and Essentials. What is it?
- 1.1 What is a Roth IRA?
- 1.2 Roth IRA Basics – Benefits and Advantages
- 1.3 Who is eligible for a Roth IRA?
- 2 More Roth IRA Basics: How do they work?
- 3 Application of Mêtis in our Roth IRA
Ever wonder “what exactly is a Roth IRA, anyway?” This section will cover some definitions, spotlight some benefits, and cover some differences between a Roth IRA and a Traditional IRA.
What is a Roth IRA?
A Roth IRA is a retirement vehicle, a type of Individual Retirement Account. In general, and if the rules are followed, when (and if you choose to) your qualified withdrawals in retirement from the account are tax-free (more on that below).
The “Roth” part of the name was established by the Taxpayer Relief Act of 1997, which named this type of IRA after Senator William Roth.
Roth IRA Basics – Benefits and Advantages
Part of learning about Roth IRA Basics could include careful consultation with your trusted financial advisor, like with any investment vehicle, to ensure this is a good fit for your unique financial situation. That said, my opinion is that the Roth IRA offers some incredible benefits! Here are some of my favorites:
Roth IRA Tax Benefits.
With the standard caveat of “if the rules are followed” and “in general” in mind, Roth IRAs are funded with your after-tax dollars (dollars that do not lower your current taxable income). Those contributions and the interest grow and when withdrawn in retirement are tax-free!
Roth IRA contributions (what you paid-in) can be withdrawn before retirement.
If you had to, this can be treated as a backup emergency fund. If you contributed $100 and then 6 years later needed to pull it out of your Roth IRA, then you could do so without penalty nor would there be any taxes. In that example, if you took out the $100 paid-in and took out the interest, then you would likely be assessed penalties and taxes on the portion that was interest (i.e. taxes/ penalties on the gains).
Roth IRA Withdrawals and the 5-Year Rule.
If you are coming up on retirement, then you should mind the 5-year window before taking withdrawals that include your gains. Additionally, remember that 59 1/2 is an important age. After that point, and if satisfying the 5-year rule, then withdrawals are tax-free. This Rule is something you’ll want to get some additional help with from your trusted financial advisor.
Additionally, remember that Roth IRA early withdrawals of gains can bring with it additional penalties and taxes. Before you draw down with a non-qualified distribution from your Roth IRA, take a moment and reflect. Be careful not to create a precedent for yourself to prematurely take money from retirement on a regular basis.
Required Minimum Distributions (RMDs).
IRS rules for traditional IRAs will require you to take money out annually (an RMD) after the age of 72. However, Roth IRAs do not. This is especially valuable if you plan on holding your Roth IRA for a longer period of time. Even today, if you are not sure about what you will need in retirement, I believe this flexibility is nice.
Who is eligible for a Roth IRA?
Many of us will be able to contribute to a Roth! Here are a couple of key points to review.
According to the IRS, for those with a tax filing status of married filing jointing looking to contribute up to the limit, modified AGI must be less than < $198,000. A reduced contribution is available and scales to 0 if MAGI is greater than or equal to $208,000.
“Backdoor” Roth IRA Conversion.
However, if you are facing upper limits, a “backdoor” Roth IRA may be possible. This is achieved by opening a traditional IRA, making a contribution, and then converting it into a Roth IRA immediately after funding it. If you find yourself in this bracket and would like to execute a strategy like this, then you’ll want to work closely with your trusted financial advisor.
More Roth IRA Basics: How do they work?
If you are feeling like this is an investment vehicle for you, then here are a few checklist items that will help you on the way toward better cultivating Mêtis in your Money Matters.
How to Open a Roth IRA.
Curious about how to start a Roth IRA? What about initial funding? This section takes you through a couple of options and outlines general elements you should anticipate.
I’ll start by saying there are many institutions supporting the Roth IRA that would be happy to get you set up. A quick Google search will make that clear. While I do not specifically endorse one company, some common names I have seen and dealt with are (in no particular order of importance): Vanguard, Fidelity, and Charles Schwab.
Make sure you do some research to see which combination of features and benefits works best for your situation.
What do I put into a Roth IRA?
A common misunderstanding is that the Roth IRA is the investment itself. Instead, think of the Roth IRA as a vehicle for carrying your investments. With that context in mind, recall the powerful tax benefits from the Roth IRA.
In a broad sense and in my opinion, I think choosing investments for your Roth IRA should give preference to those which would typically generate higher taxes. For example, mutual funds with higher churn could benefit from this treatment.
What documents are needed in order to open a Roth IRA?
Check with the institution you decide to open an account with to get a specific list. Common items include a form of identification such as a driver’s license, your social security number, and banking information (routing and checking numbers).
Funding, and contribution limits for a Roth IRA.
According to the IRS, total contributions for traditional and Roth IRAs in 2021 are limited to $6,000 (younger than 50) or $7,000 for age 50 and older for catch-up contributions.
You can fund your newly minted Roth IRA from your linked account, or you could transfer and roll over an account from another company as well. I have done this step myself and it was relatively quick and painless. The key element was picking a good customer-focused company to pilot the process.
Leaving your Roth IRA for the next Generation?
Make sure you designate beneficiaries (and update them later as necessary) when you establish your Roth IRA. Additionally, if you and your family are using a Trust, make sure to work with your attorney to ensure the Roth IRA is properly documented.
Thinking about leaving your Roth IRA for your children? As we established earlier, there are no RMDs for the Roth IRA while you (the original owner) hold it. You can leave it all for them!
However, make sure to consult with a trusted and skilled financial professional. You will want to document and ensure those inheriting the Roth IRA pay close attention to the RMDs associated with that process. These rules and others are ones you’ll want to work through and understand better for your unique financial situation.
Application of Mêtis in our Roth IRA
I hope this breaks the Roth IRA “ice” for you! My wife and I have tried to make the best decisions with the resources we have had at the time. We’ve tried to prioritize the retirement accounts and savings accounts we contribute to. Regardless of what we think we will make in retirement years, I like the Roth IRA for the benefits we listed earlier in this post. Additionally, I would prefer to pay taxes now, up-front, and make qualified withdrawals tax-free in my retirement. Here are a few more ideas on the hierarchy we try to follow. Just my two cents…
Roth IRA or 401(k)?
In our situation, my employer provides a 401(k) match. I contribute up to that number, and I do not deviate from this amount. This is where we invest first, and it allows us to take full advantage of any matching benefit. Beyond that, I move on to the HSA.
Roth IRA or HSA?
I really like the HSA, and the triple-tax benefit of the HSA is quite valuable to us. After the 401(k), we try our best to max the HSA as the next item on our hierarchy.
After these two steps, if we have money left over, the Roth IA is always there to pick up the slack. We love having it!