Roth IRAs: A beginner’s guide

Today’s post comes from another BHB mentee, Pat Murphy, the publisher of Feeling Financial. Pat is a personal finance blogger who focuses on how we make important financial decisions. His website discusses personal finance topics while examining how our thoughts and personality affect our behavior.

It’s always nice to have options. I like being able to choose what I get, and I especially like having the ability to change my mind about something later. But in some areas (like planning for retirement), you just have to commit get started, because building up a nest egg is best done over the course of many years.

Fortunately, there is a way to save for retirement while keeping some of your options open. A Roth IRA lets you enjoy the tax benefits you get in a retirement account, while allowing you to use the money for something else (such as education funding or whatever else happens to come up).

What is a Roth IRA?

First, a few boring facts about Roth IRAs, which might help you figure out if the account makes sense for you. A Roth IRA is a type of individual retirement account (that’s where the “IRA” comes from). These accounts are “individual” because they’re not linked to your employer like a 401k is, and that means you have full control over what happens with the account. (Jana’s note: The Roth IRA is named for Delaware Senator Bill Roth. He also has a bridge named after him. You’re welcome).

Like most retirement accounts, you’re supposed to leave the money in your Roth IRA until “retirement age,” which the IRS likes to call age 59.5. But Roth IRAs make it easier to get to your money early without hefty tax penalties (we’ll talk about that in a minute). You also get the same tax benefit you get from almost any other retirement account: any money you earn in the account (from interest, dividends, or capital gains) is not reported to the IRS every year and taxed. Instead, you keep 100% of the earnings in your account and reinvest them for even more growth.

Roth IRAs are often called “after-tax” IRAs. The money you put in the account doesn’t help you on your tax return this year (on the other hand, if you use a Traditional IRA, you might be able to get a deduction and reduce this year’s tax bill). While that may seem like a drawback of Roth IRAs, the benefit is that you’ll be able to take money out of the account without paying taxes (with a Traditional IRA,you’ll have to pay income tax on all of the pre-tax money you pull out of the account – plus earnings – no matter how old you are). When you pull money out of your Roth account, assuming you follow all of the rules, you’ll get to spend all of that money – you won’t have to come up with any extra to pay taxes.

The Flexibility

We just went over some fairly complicated rules, so you may be thinking that a Roth IRA sounds anything but flexible. Here’s the gist of what the Roth IRA offers: you can take your contributions back out of the account at any time without taxes or penalties. The money you contributed was all after-tax money, so they can’t tax you again when you take it back out.

That’s a nice feature for an account with otherwise powerful tax benefits. You get to change your mind if you decide that you need that money elsewhere. Just keep good records of how much you’ve contributed to your Roth, and you’ll know how much you can get back out if you need to.

The tricky part is that you get to take your own contributions back,but you can’t get to the earnings on your contributions unless you follow a few rules (or unless you’re willing to pay taxes and penalties). Those rules require that you have had the money in your Roth for at least 5 years, and that you wait until you’re at least
59.5 years old. There are a few other details, but the important things to remember are age 59.5 and 5 years.

Ways to Use a Roth IRA

Of course, Roth IRAs are designed with retirement in mind. And that’s one great way to use them. Save some money each year (currently you can contribute up to $5,500 per year, plus an additional $1,000 if you’re over 50 years old), and you’ll have a nice chunk of tax-free money waiting for you in your golden years.

You can also use a Roth IRA for other goals. For example, you might use a Roth to save money that is earmarked for a child’s education. But if it turns out that you don’t need the money (because your child is smart, like her parents, and gets a scholarship) you can just leave it in the IRA and it’ll be there when you retire – growing tax free. Or, if your money is invested conservatively, you can even think of your Roth IRA as a “backup” emergency fund (but it’s really best to have your primary emergency fund in a bank account).

What happens if you spend all of the money in your Roth IRA, including the earnings? If you’re under the age of 59.5 or you haven’t had the money in your Roth for 5 years, you’ll have to pay income tax on the earnings portion of your withdrawal. You might also have to pay an additional penalty tax of 10% of your earnings. However, there are a few exceptions to the penalty tax (such as higher education expenses for you or a family member, or substantial medical expenses). Unfortunately, you can’t get around the income tax if you take an early distribution.

How to Open a Roth IRA

If you don’t have a Roth IRA, they’re easy to open. Any bank, credit union, online brokerage, or financial planner can help you open one. A Roth is just a type of account with certain tax characteristics, but it can hold almost any kind of investment you want. (Jana’s note: if you open one and are really bad about remember to actually set foot in the bank to make a deposit into the account like a certain unnamed personal finance blogger who I don’t want to embarrass, check to make sure you can do an automatic deposit. If you can, sign up for that).

Keep an eye on the income rules if you’re thinking of contributing to a Roth IRA. You have to earn enough to contribute, but if you make too much you aren’t allowed to contribute at all. In 2013, you must have a
modified Adjusted Gross Income (AGI) below $188,000 if you’re married and filing jointly (or $127,000 if you’re single). These things can be complicated when you’re doing it for the first time, so just use this post as a starting point. Talk to your tax preparer before you do anything, and read through all of your account opening paperwork carefully so that your Roth becomes a flexible and powerful tool – not a source of anguish.

Now that you know the basics, think of some of your goals and whether or not a Roth IRA can help you reach them. If you’re not really sure what your goals are yet, maybe the flexibility of Roth will come in especially handy.