Roth IRA fundamentals

In short

A friend of mine once told me he wished someone had explained the Roth IRA to him at twenty five, and not at fifty. If you are thinking about one, the idea is simple enough to act on. You put in money you have already paid tax on, and the growth comes out tax free later if the plan's rules are met. The IRS sets a yearly limit of the current figure, which the official source publishes each year, and the money has to come from paid work. Your income can shrink or shut off what the rules let you add, so check the income range before you fund anything. I once watched a neighbor learn that rule the hard way, and it cost him a headache. Read the whole page, and you will know what to check first.

The whole of it

What it is

I grew up around folks who kept their savings in a coffee can, and I have a soft spot for anyone who saves at all. If you are saving for a day when the paychecks stop, a Roth IRA is one of the tools you can use. IRA stands for individual retirement arrangement, which is a special account you open on your own, apart from your job. The word Roth is the name of the senator who pushed the idea through, and it tells you how the tax works. You pay income tax on the money first. After that, the growth can come out without more tax.

That is the reverse of a traditional IRA. With a traditional IRA, the saver may get a tax break now, and the tax bill comes later. With a Roth, the bill comes now, and the break comes later. Neither is better in every case. It depends on what a person's tax rate looks like today and what it may look like in the future, and nobody can promise that part.

One more thing is worth saying. A Roth IRA is a kind of container, not a kind of investment. The account holds whatever the account holder picks from what the firm offers. The tax rules wrap around the container. They do not tell anyone what to put inside.

How it works

You have probably heard that money in a Roth grows tax free, and that is mostly right. Let me walk through the parts that make it so. The account holder opens an account at a bank, a brokerage, or a fund company. Then the holder adds money from paid work, which the IRS calls compensation. Wages, tips, and self employment income count. Interest from a savings account does not.

The IRS limits how much can go in each year. That limit is the current figure, which the official source publishes each year, and it can be higher for people at or past the age set in the current figure, which the official source publishes each year. The limit covers all of a person's IRAs added together, so splitting money between two accounts does not double it. A person also cannot put in more than the income they earned that year.

Now for the part that surprises people. Income can cut the amount a person may contribute. The IRS publishes income ranges for single filers and married couples, and within those ranges the allowed amount shrinks until it reaches zero. Those ranges are the current figure, which the official source publishes each year for single filers and the current figure, which the official source publishes each year for married couples filing together. The test uses a figure called modified adjusted gross income. That is your income after a few adjustments the IRS spells out.

Taking money out has its own rules. The money a person put in, called contributions, can come out at any time with no tax and no penalty. Growth is different. The growth comes out tax free only if two things are true. The account has to be open for at least five tax years, and the holder has to be past the age in the current figure, which the official source publishes each year or meet another reason the IRS lists, such as disability. Pull growth out too soon, and tax and a penalty can apply.

The numbers, and where to find yours

Folks sometimes ask me where to look so they do not have to trust a stranger's word. I tell them to go to the source. The IRS runs a page on Roth IRAs and another on contribution limits, and both are updated each year. The IRS also publishes Publication 590-A, which covers contributions, and Publication 590-B, which covers withdrawals. Those are the official books.

You will want a few figures from your own life. First, find your earned income for the year, which sits on your pay stubs or your tax return. Second, find your modified adjusted gross income. That figure does not appear on a pay stub, so the worksheet in Publication 590-A walks through it from the tax return line by line. Third, check the yearly limit, which is the current figure, which the official source publishes each year, and compare your income against the current figure, which the official source publishes each year or the current figure, which the official source publishes each year, depending on how you file.

Write them down. A number on paper is easier to trust than a number in your head.

A worked example

Let me tell you about a woman I will call Maria. She is thirty two and earns a salary of $52,000 a year. She files as a single person. Her salary is her only income, so her modified adjusted gross income is close to $52,000 as well. A figure like that gets compared against the single filer range in the current figure, which the official source publishes each year for the year in question, because the IRS resets the range from time to time. Her employer has no retirement plan, so she opens a Roth IRA on her own.

Maria decides to save $250 a month. Twelve months at $250 a month is $3,000 a year. For the story, say that sits under the yearly limit in the current figure, which the official source publishes each year, and it is well under her earned income of $52,000, so the rules are met. She pays income tax on that $3,000 first, as part of her normal pay.

Now picture the growth. Say her account earns 5 percent a year. That rate is only a made up figure for the story, and no one can promise it. Her first year of savings, $3,000, grows by $3,000 times 0.05, which is $150. She ends the year with $3,000 plus $150, which is $3,150, from that deposit alone. Left alone, that single $3,000 deposit would be worth $3,000 times 1.05 raised to the tenth power after ten years. That works out to about $4,887. The extra $1,887 is growth.

Because the account has been open more than five tax years and Maria is past the age in the current figure, which the official source publishes each year, that $1,887 can come out with no income tax. Had she put the same $3,000 in a regular taxable account, tax on the growth could have taken a bite. The Roth is built to avoid that bite.

She does not need to guess at the tax part. She can read Publication 590-B, and she should. A friend of mine keeps his copy on the shelf next to his tax folder.

Where it goes wrong

I have seen good people make small mistakes here, and I want to spare you a few. The first is putting in too much. If a person adds more than the limit, or adds money while earning too much, the IRS can charge a yearly tax on the extra amount until it is fixed. The fix is to take the extra out, along with any growth on it, by the deadline the IRS sets. Many firms have a form for that.

The second mistake is pulling growth out too early. A person who takes out earnings before the account is five tax years old, or before a qualifying reason, may owe tax and a penalty. Contributions come out freely, but the order of withdrawal matters, and the IRS rules put contributions first. Read Publication 590-B before you move money.

The third is mixing up the account with what is inside it. A friend of mine opened a Roth IRA and left the cash uninvested for a year. The money sat in a settlement fund, earning little. The tax benefit is real, but it only matters if there is growth to protect. Fees matter too. A fund with a high yearly cost can eat the very growth the account is meant to shelter. Look at the fee, which every fund must disclose.

The fourth is forgetting the income test. Someone whose pay rises during the year may cross the line without noticing. It is worth a second look at tax time. Easy to miss, though.

Questions to answer before you leave this page

Do you have paid work this year, and how much did you earn? What is your modified adjusted gross income, and where does it fall against the current figure, which the official source publishes each year or the current figure, which the official source publishes each year? Have you checked the yearly limit of the current figure, which the official source publishes each year, and do you know how much of it you could add? Does your plan at work offer a Roth option too, and have you read what it charges? Are you saving this money for a day far off, or might you need it soon, since growth comes out cleanly only after the five tax year and age rules are met? Which firm will hold the account, and what are the yearly fees on the funds it offers? And have you read the IRS pages and Publications 590-A and 590-B, so the rules come from the source and not from a neighbor on the porch?