A Roth IRA is an investment vehicle that allows you to contribute after-tax dollars and grow them tax-free. Then, as you approach retirement, you can withdraw them tax-free and penalty-free.
However, there are some things you should know about the Roth IRA before you decide to open one. The following are some of the key features you should consider:
Tax-Free Withdrawals
If you're a saver with a Roth IRA, tax-free withdrawals can be a real asset. They allow you to use your savings for things that might not be possible with a taxable account, such as an emergency fund.
However, you have to keep in mind that there are some limitations.
The first rule is that you have to hold a Roth IRA for at least five years before you can withdraw earnings from it without taxes and penalties. This requirement applies to both contributions and conversions.
You must have earned income (like wages, salaries, bonuses, and self-employment compensation) to contribute to a Roth IRA. Investment income, Social Security benefits, and retirement distributions do not qualify.
If you're planning to make a Roth IRA withdrawal, talk with a financial planner or other tax professional to learn about the exceptions that apply to your specific situation. These exceptions are subject to change, so it's important to know what's available at the time you plan your withdrawal.
No Required Minimum Distributions
While other IRAs, such as traditional IRAs and simplified employee pension (SEP) IRAs, require minimum distributions in retirement, Roth IRAs don't. This means that you can withdraw money as you need it tax-free, or give it away to family members or a charitable organization.
You may also convert your Roth IRA to a traditional IRA, but only after five years have passed. If you convert before the five-year period has ended, you may be required to pay a 10% Roth IRA early withdrawal penalty on the amount you convert.
The RMDs are calculated based on two factors: your total retirement account balance as of December 31 and an IRS estimate of your life expectancy. If you have a spouse, their age must also be factored into the calculation.
If you're planning to retire, you should start taking your RMDs by April 1 following the year you reach age 72. This will give you time to allocate the funds for living expenses, start a new savings account, invest in stocks or give them to your heirs.
Flexibility
Roth IRAs offer flexibility that can be appealing to people with long-term earning potential. The account owner's funds grow tax-free until retirement, when they can be withdrawn without penalty.
The flexibility in Roth IRAs can be especially helpful for younger workers who aren't yet confident they'll need a lot of savings for retirement. Using this type of account could help ensure the money they're saving isn't used for other needs, such as a new car or vacation.
A 25-year-old who contributes $6,000 to a Roth in 2022 would have more than $1 million by the time they reach age 66.
However, it's important to remember that a Roth can only be accessed in certain situations, and withdrawing the account early may impose a tax penalty. That's particularly true if you're under 59 1/2 and take a distribution of earnings within five years of contributing to the account.
Investment Choices
There are a wide range of investments you can include in your Roth IRA. The best choice for you depends on your risk tolerance, time until retirement and goals.
Stocks, for example, are an excellent long-term investment. They typically grow at a rate of about 10% per year, making them a good match for a Roth IRA.
You can invest in stocks yourself or buy ETFs and mutual funds that contain your favorite companies. You should also consider investing in small-cap stocks, which have the potential to grow rapidly and are less risky than large caps.
You can also include alternative assets, such as commodities. Some investors enjoy adding this asset class to their portfolios because it provides diversification benefits and can hedge against inflation. However, you should be aware that many commodities funds rely on futures contracts for exposure.
