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There’s been much discussion about the advantages of Roth IRAs compared to traditional IRAs, but it’s time for another look as the Roth, often referred to as 'the golden child of the retirement planning world' by NerdWallet, marks its 20th anniversary.
The primary distinction between a Roth IRA (individual retirement account) and a traditional IRA lies in the timing of taxation: With a Roth IRA, you contribute funds that have already been taxed, so when you make withdrawals in retirement (after age 59½), you won’t pay taxes on either the contributions or the earnings. It’s like paying your taxes in advance.
As I wrote about before, Roth IRAs are more appealing than ever. With the recent GOP tax reform, tax rates are likely as low as they will be for a long time. This means you’re contributing at a lower tax rate than what you may face in the future, securing that benefit for yourself. While this has always been a draw for younger workers (who tend to be in lower tax brackets), it’s now beneficial for a much broader range of people.
Another significant advantage is that there’s no penalty for early withdrawals of your original contributions (not the earnings). This makes it somewhat like an emergency fund. Unlike other accounts such as your 401(k) or traditional IRA, where early withdrawals come with penalties, this flexibility can be invaluable, especially in times when savings are stretched thin and unexpected expenses arise.
Roth IRAs don’t have minimum distribution requirements, allowing your heirs to inherit your account. In contrast, traditional IRAs require minimum distributions starting at age 70½. Additionally, you can use a Roth IRA to complement a 529 plan.
The downside: Your contribution limits begin to decrease if your income exceeds $120,000 for individuals (2018) or $189,000 for married couples filing jointly. Contributions phase out completely at $135,000 for individuals and $199,000 for married couples.
How to Set Up a Roth IRA
If you have a 401(k) from your employer, be sure to contribute up to the company match. Afterward, consider allocating part of your paycheck to a Roth IRA (current annual limits are $5,500, or $6,500 if you're 50 or older), especially if your employer offers limited investment options within the 401(k).
To start your Roth IRA, choose a brokerage, bank, or robo-advisor. As recommended by RothIRA.com, here are some questions to consider before opening an account:
Are there any fees associated with opening or maintaining the account?
Does the company provide customer support that meets your needs, whether through online chat or phone assistance?
Does the platform offer the investment options you’re looking for, such as ETFs, target-date funds, actively managed funds, or stocks and bonds?
What are the trading costs? This is particularly important if you plan on making frequent trades within the account.
If you choose a brokerage like Fidelity or Merrill Edge, here are additional factors to consider about their offerings, according to NerdWallet:
Has minimal or no fees for maintaining the account.
Offers a wide variety of no-transaction-fee mutual funds and commission-free exchange-traded funds.
Provides excellent customer support and investment education, particularly helpful for those new to the world of investing.
Features low account and fund minimums—these are distinct. It’s important to choose a broker with no initial deposit requirement, but don’t overlook the fact that many funds may require a minimum of $1,000 or more. Otherwise, your funds may remain idle in cash until you can meet the minimum investment requirement.
You’ll then choose your investments, such as individual stocks, bonds, mutual funds, or possibly other assets like options. If you prefer simplicity, you can go with a target-date fund or let an advisor pick your investments, though both of these options come with additional costs. If you’re avoiding extra advisor fees, consider mixing index funds and ETFs for a more cost-effective strategy. As NerdWallet recommends, you could even replicate the portfolios displayed by robo-advisors if you’re unsure of what to invest in but don’t want to pay extra fees for advisory services.
Once you’ve determined your asset allocation, make sure to set up automated contributions so you’re regularly adding to your account—just be sure not to exceed the $5,500 annual limit. After that, sit back and enjoy the benefits of your tax-free growth.
