Roth IRA

There are special accounts in the U.S., which are used to save money for retirement, such an account is called an individual retirement account or IRA. IRA, in its turn, has several types. One of them is a Roth IRA, which provides advantages in the tax field for its holders.

The main advantage of a Roth IRA lies in that all earnings from the money you contribute won’t be subject to taxation. It means that you may withdraw your account income without paying any taxes as well. However, it should be remembered that you have to pay taxes for your contributions.

Main principles of Roth IRA work

Since an IRA is an individual account, it’s made by an employee separately from the employer. An employee may put the earned money into this account. Note that the money must be part of your legal income, i.e. money on which you’ve already paid taxes. Doing this allows you not to pay any taxes on further earnings made with the help of the Roth IRA.

A Roth IRA may be formed of several components, such as transfers, conversions, rollover contributions, spousal IRA contributions and regular contributions. The requirement for the regular contributions is that they are made in cash (although it may be checks or money orders), securities and properties can’t be a component of such contributions. For sure, the amount of money an individual may contribute to the IRA is limited. Traditional IRA and Roth IRA have the same limitations. In case you have more than one IRA, you should remember that limits are the same in all the accounts, it’s impossible to contribute the amount that exceeds the maximum.

Another beneficial thing about the Roth IRA is that it isn’t as restrictive as a traditional IRA or 401(k). For example, there are no time limits in regard to maintaining the Roth IRA and no required minimum distributions or RMDs), etc. On the contrary, a traditional IRA lets you deposit pre-tax money. This is how the Roth IRA and the traditional one are different. Also, all money that is withdrawn from the traditional IRA is subject to taxes.

Other allowable Roth IRA components

The list of components that may become a part of your Roth IRA is large. It can be stocks, certificates of deposit or CDs, mutual funds, bonds, exchange-traded funds or ETFs, etc. Moreover, nowadays, cryptocurrency may become a part of your Roth IRA.

However, although cryptocurrency may be in an IRA, it can’t be contributed directly. It means that firstly you need to open a Bitcoin IRA, which was specially created for such purposes. Then, the opportunity to invest in cryptocurrency appears. Note that life insurance and derivative trades aren’t allowed on any IRA, they are prohibited by the Internal Revenue Service (IRS).

The Roth IRA itself has several categories. For instance, in case you want your IRA range of investment to be as wide as possible, you have an opportunity to open a Roth self-directed IRA, or shortly SDIRA. This category allows you, the investor, to take the managerial role. Thus, a brand-new way of filling an IRA becomes possible. Apart from most known investments such as stocks, bonds, etc., this category of Roth IRA allows you to include in your retirement portfolio such things as real estate investment, gold, even a franchise business, etc.

How to open Roth IRA

Opening a Roth IRA may be carried out only by an institution that officially has got approval from the IRS. Although the list of such organizations comprises brokerage companies, federally insured credit unions, banks, etc., most people set up their IRAs with the help of brokers. Note that an individual can open your Roth IRA at any time he or she wants, the IRA owner must contribute for a tax year before the tax-filing deadline. Most of the time, the deadline is April 15.

After opening an IRA, there are two documents that are given to the IRA owner, the first is the IRA disclosure statement, the second is the IRA adoption agreement and plan document. These documents give profound information about how the IRA rule and regulations are working. They set a new agreement with two parties, one of them is the IRA owner, while the second is the IRA trustee.

The interesting fact is that not all institutions that provide IRAs create them in the same way. Some of them impose more limits on possible investments, others give their clients a wide range of variants. It isn’t a secret that each institution sets its own fee’s rules for the Roth IRAs. These sets of rules may affect your retirement investment in extremely different ways.

Depending on their own preferences and risk tolerance, investors may choose a suitable institution specialized in Roth IRAS. There are investors that are planning to be more active and conduct many trades. Thus, they need a provider with low trading costs. Moreover, there are providers that charge a fee for inactivity, in case your account isn’t involved in trades for a certain period of time. Others offer a wider range of stocks and ETF. Others have a list of requirements that a holder must meet. For example, providers usually set an account's minimum balance. It isn’t rare or weird for them. However, in some institutions the minimum may be higher than in others. If you already have an account at a bank, and you plan to open a Roth IRA, you should learn whether your bank provides any IRA fee discounts. Typically, banks gladly provide discounts for their customers.

Possible contributions to Roth IRA

The IRS controls how much money an individual puts into the Roth IRA and the type of any contribution. The basic rule about the amount is that the money an individual puts into the account can’t exceed the earned income for the year. The basic rule about the type of contribution is that an individual may put only earned income to the account.

For people who work for employers, the money that is allowed to be put into such an account is typically reflected in the Box 1 of the Form W-2. It may be wages, commissions, bonuses, wages, etc. On the contrary, for self-employed, it’s compensation as well. In this case, compensation is the net income without deductions.

In some cases, an individual is allowed to contribute alimony, money for child support. The list of allowed contributions is quite long and comprises interest income, dividends from stocks, passive income in some cases, etc.

Limits for withdrawals

The main principle of any Roth IRA is that an individual may take out his or her contributions at any time. These withdrawals are both non-taxable and penalty-free. For example, if an individual withdraws the amount of money that equals to the total sum that has been put into the account, then it isn’t regarded as taxable and doesn’t imply any penalty for it.

The limits appear at the moment an individual wants to withdraw earnings generated by the account. In order to take out earnings, they either must be regarded as a qualified distribution or the account must be more than five years old. Moreover, the distribution requires other conditions (it isn’t necessary to fulfill all of them), some of them are presented below:

• The person must be older than or at least to be of age 59 1/2.
• The holder became disabled.
• The beneficiary may receive the money in case of the holder's death.
• The money will be used for buying a building or rebuilding the first home. The limit is $10,000 per lifetime.

5-year rule

There are rules for withdrawing earnings from the Roth IRA. In case an individual withdraws earnings without meeting several requirements, it means that the individual is subject to penalty or the withdrawals may be subject to taxes. Both in some cases.

If the Roth IRA exists more than five years and its holder is of age 59 1/2 or older, then the earnings aren’t subject to any penalties and taxes, the holder may feel free to withdraw it.

If the Roth IRA exists more than five years, but the holder is younger than 59 1/2 the earnings are taxable. However, there are cases that release you from taxes. These are the first house purchase, a permanent disability and death of the holder (then the holder’s beneficiary uses money).

If the Roth IRA exists less than five years and its holder is of age 59 1/2 or older, then the earnings are taxable, but the holder is relieved from penalties. Thus, withdrawals aren’t impossible, but they involve several difficulties.

If the Roth IRA exists less than five years, but the holder is younger than 59 1/2, unfortunately, all earnings are taxable and in case the holder decides to take them out they are also subject to penalties. There is no way to avoid taxes, but there are ways to avoid penalties. The first is to use money to buy a house, but it should be the first time you purchase such a building. The second way is to spend money on education purposes. Note that these expenses must be qualified. The third way is to pay for medical services that can’t be reimbursed. Disabled are usually the ones who incur such expenses. The last way is not a way, but in case the holder dies, it’s possible to take out money and be released from penalties.

Qualified distributions

There are several cases that may be covered by the money that have already been put into the Roth IRA. In these cases, the holders aren’t subject to tax and/or penalties. Cases are presented below:

• Higher education. Note that only qualified expenses may be covered. Thus, holders may pay for their own education and/or for the education of their dependents. The expense is regarded as qualified in case it’s tuition, books, fees, supplies, demanded enrollment equipment, etc. It must be used in the same year that the act of withdrawal takes place.
• Unreimbursed medical expenses. In case the amount spent on unreimbursed medical expenses money is higher than 7.5% of the holder’s AGI for prior tax years, then the holder is able to use the account money.
• Childbirth or adoption. It’s permitted to spend the account money in case childbirth or adoption is made within 1 year, and it’s the same year of a withdrawal. Note that expenses must be less than $5,000.
• Medical insurance. In case the holder lost the job, then it’s possible to spend the account money.

You should remember that withdrawals of the money from the Roth IRA that has been put into the account this year may lead to the reverse of the contribution. For instance, the holder has contributed $100 this year and earned $10. It means that the holder is able to withdraw $100 without any taxes and penalties. However, in case the holder decides to withdraw the generated money, he or she must take into account that it’s subject to taxes.