In the US, IRAs – Individual Retirement Accounts, or Individual Retirement Arrangements – are used to save while earning an income, for life after retirement.
There are a range of types of IRA, including the Roth IRA which has a unique set of rules regarding taxation, contributions, and distribution. Using IRAs, including a Roth IRA product, can be a smart way to ensure your future financial wellbeing in a tax efficient way.
This guide walks through the basics of Roth IRAs, and provides resources for you to learn more and get started saving. It’s worth noting upfront that the rules around IRAs are complex and may be subject to change. Depending on your situation, you might need personal advice to help you choose, grow, and use your own traditional IRA or Roth IRA.
What is a Roth IRA?
A Roth IRA is a specific type of retirement account. Roth IRAs vary from traditional IRAs in a number of ways – in particular, in the way they’re taxed.
With a Roth IRA you contribute after tax income. You can always withdraw your contributions penalty free – and as long as you meet preset criteria, you can also withdraw your investment earnings in future without paying federal taxes. Traditional IRAs work the other way around – you fund the IRA pre-tax, and then pay the tax on distribution.
You may have both traditional and Roth IRA products. However you’ll have a maximum contribution limit, which is annually adjusted, and which applies to a combination of all your IRA products.
Here are the key differences you’ll find in a Roth IRA compared to a traditional IRA:
- Unlike traditional IRAs, Roth IRA contributions are not tax deductible
- You can contribute to a Roth IRA only if your modified income is below set limits
- Qualified distributions from a Roth IRA are not taxed – however, you may choose to take distributions early and pay extra tax instead
- There’s no requirement to take minimum distributions, unlike traditional IRAs which must start distributing at a set age
How does a Roth IRA work?
With a Roth IRA you’ll contribute after tax dollars, and can later make withdrawals without paying tax. This is advantageous if you think you’ll pay higher taxes when you’re retired than at the time of contributing. The contributions you make into your account are invested and grow. At any time you can make withdrawals of the contributed amounts, which can be distributed tax free. However, you won’t be able to withdraw any earnings from the account unless you meet a fixed set of criteria. We’ll cover these requirements later.
You can open a Roth IRA with a bank or other financial organization, and pay in up to a set annual limit. However, you can only contribute to a Roth IRA if your annual income – or your household income if you file for joint tax – falls below fixed limits.
What is an IRA account?
IRA accounts, including the Roth IRA, are intended as a way to save for retirement. These account types have specific sets of rules for contributions and distribution which include different tax arrangements compared to normal savings accounts. Opening an IRA – or multiple IRA accounts – is a good way to save for retirement in a tax efficient way.
Types of IRAs
There are multiple types of IRA, and to find the best product to suit your needs you’ll want to do some research. As well as Roth IRAs, you may come across the following:
- A traditional IRA from a bank, credit union or similar
- An individual retirement annuity which you can purchase from a life insurance company
- A SIMPLE IRA
- A SEP – Simple Employment Pension
- An Employer and Employee Association trust account
Do I qualify for the IRA account?
You can open a traditional IRA if you or your spouse earn a taxable income, and are aged under 70.5 years. You may be able to open a Roth IRA if you fulfil certain income requirements, which are adjusted annually.
In 2021, a single person can contribute to a Roth IRA if their income is up to USD125,000, with partial contributions available up to an income of USD140,000.
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TransferWise international payments use the mid-market exchange rate with no hidden fees. You’ll only ever pay a low, transparent conversion charge which can work out far cheaper than relying on your regular bank. That means more money left for yourself.
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How to open a Roth IRA
The steps to open your Roth IRA are fairly similar, no matter which provider you choose to use. Make sure you research options before you choose an IRA product from your bank or other institution, as fees and investment options do vary. Here’s what you’ll need to do:
- Check you’re eligible for a Roth IRA using the latest guidance from the IRS
- Choose where you’ll open your Roth IRA – check out the fees, service levels, investment options and convenience before you decide
- Apply for your Roth IRA. You might be able to do this online, but some providers require you to visit a branch or mail in paperwork
- Choose how you want your contributions to be invested – you could design your own portfolio, or choose a target date or life cycle fund provided by the bank, for example
- Pay into your Roth IRA by bank transfer – you may be able to set up a regular payment depending on the bank’s policies
How to contribute to the Roth IRA?
You contribute to your Roth IRA after tax. This means that you’ll need to arrange bank transfers or a regular payment direct from your bank account, into your Roth IRA account.
Contributions can be made throughout the tax year, or as a one off payment. You can usually pay into your account up to the tax filing date. However, it’s worth noting that as soon as your payment is received into your Roth IRA account, it will be invested. This may mean it generates better returns that it would have in your regular bank account.
When can I withdraw from my Roth IRA?
You can always withdraw your Roth IRA contributions without tax or penalties. Don’t forget, you paid with after-tax dollars, so you won’t be penalised for accessing this money later. However, different rules apply for the money you earn on your contributions.
You can withdraw your earnings tax free if you’re aged over 59.5 and have had the Roth IRA for at least 5 years. There are also a few exceptions which allow you to access funds early – if you’re buying a primary residence, or if you sustain a permanent disability for example. In these cases, some withdrawals are still deemed ‘qualified’ under tax rules, and will be allowed tax free.
If you need to access your funds before you’re 59.5, and without any of the other extenuating circumstances which allow for exceptions, you may pay a penalty. At the time of writing, this can mean you have to pay tax on the income, and a 10% early access fee. However, even in this situation there are exceptions. For example, if you’re using the money to cover qualified education costs, medical expenses or childbirth, you may be able to make withdrawals without penalties.
The rules around Roth IRA disbursements are complex and subject to change over time. Make sure you understand them fully, and take professional advice if you’re unsure of the best way to pay, access and grow your funds. Used right, traditional and Roth IRAs are a great way to save and grow your investments, so you can have a better quality of life after retirement.