Should I Open a Roth IRA: The Do’s and Don’ts for Retirement

The retirement account known as the Roth IRA is an alternative to the regular Traditional IRA and 401(K). But to reap the benefits of this highly desirable account you need to fit certain criteria. There are a lot of pitfalls you can avoid when looking at retirement accounts, you just need to know what they are.

In short, to open a Roth IRA you need to have an annual income of less than $139,000 if you are single, and less than $206,000 if you are married. In addition you need to be a resident in the U.S. and have a social security number.

Now… If you earn more than the maximum income limit, there is a ‘Backdoor’ into the Roth IRA, as well as a loop-hole if you live abroad. I think everyone who is eligible should open a Roth IRA as they are the rockstars of the investment world. You can earn tax free retirement income, while also having access to your savings.

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What is a Roth IRA?

A Roth IRA is an individual retirement account in which post tax income is invested and all earnings are tax free. People who are at least 59.5 years old, or have had the account for more than 5 years can take distributions from the account, including earnings tax & penalty free.

Your investments, meaning the deposits you make into the account can be accessed at anytime with penalty or tax, but you can not withdraw earnings until you are 59.5 years old.

How Roth IRA’s Works

Here’s some basic steps so you can understand how a Roth IRA is opened and what happens throughout your investment:

  1. Open and fund your free account with M1 Finance: M1 Finance will do all the work, just open an account, fund it, and choose you risk tolerances. This account will be where you monitor the success or potential failure of your investment. You can invest up to a maximum of $6,000 per year ($7,000 if you are over 50 years old).
  2. M1 Finance will invest your money: Once you have selected whether you want to invest yourself, or let M1 Finance do it, your money will be invested in a range of ETF’s, Individual Stocks, Bonds, Bond Funds, and REIT’s.
  3. Your returns will be reinvested: To gain full advantage of compound interest M1 Finance will reinvest all of your earnings to build your account balance. Alongside regular deposits, you account should grow quite quickly.
  4. Hard times hit: If you find yourself in financial trouble in near future, don’t worry. You can withdraw your initial deposits without penalty, and your earnings will continue to grow.
  5. Reap the reward: Assuming M1 Finance have done a good job as they usually do, once you reach 60 years old you can start to withdraw you account balance tax free as it continues to grow. Or you can leave it longer, it’s up to you.

The reason your earnings become tax free is because you are investing money you have already paid tax on. This is what I call delayed gratification.

Also, unlike Traditional IRA’s or 401(K)’s, you can leave your Roth IRA balance untouched for as long as you want. Once you hit 70 the IRS will start taking money out of your Traditional IRA, with a Roth IRA this is not the case. You can even pass the balance over to your next of kin.

What You Need to Open a Roth IRA?

First things first, to open a regular Roth IRA with no hiccups you will need:

  • An earned income of which you pay tax on.
  • You must earn less than $139,000 as of April 2020.
  • Social Security Number.
  • Government issued photo identification.
  • You must have either a bank account or savings account.
  • Your employer’s name and address (Optional).

For most U.S. residents this information will be easy to acquire. But for U.S. citizens living abroad, people who earn more than $139,000, or those filing jointly with a spouse, this can get difficult.

Can I Open a Roth IRA While Living Abroad?

Contributing to a Roth IRA or any IRA for that matter while living abroad depends on your foreign income. The Foreign Earned Income Exclusion for U.S. Expats is the most common tax benefit used for U.S. citizens living abroad. It allows you to exclude all or a portion of your income from U.S. taxes.

If you exclude all of your foreign income from U.S. taxes, you are not eligible to contribute to a Roth IRA. However, if you only exclude part of your income, or claim foreign tax credit, you may still be able to open and contribute to a Roth IRA.

For more information I highly recommend the guys over at Expat Tax Advisors. They will be able to help you with almost any problem.

What if I Earn More Than $139,000?

This is where we start talking about the ‘Backdoor’ Roth IRA.

The Backdoor Roth IRA is not an official retirement account, it is a nickname given to a complicated, IRS-sanctioned method to give high-income taxpayers the ability to invest through a Roth IRA.

This is how it works:

  • A high-income taxpayer has opens a Traditional IRA and funds it to the yearly limit.
  • The person then rolls over the balance in their Traditional IRA into a Roth IRA, there is no maximum transfer limit to this rollover.
  • The tax becomes payable on the transfer.

Another way to do this, so you don’t have massive tax bills:

  • The investor opens a 401(K) but only contributes money they have already paid tax on.
  • The 401(K) can then be rolled over into a Roth IRA without the big tax bill.
  • The only tax payable is on earnings made in the 401(K) during the year.

The Backdoor Roth IRA is a great idea for high-income taxpayers to bypass the IRS regulations on earning limits. Not only that, it allows the person taking advantage of this to contribute more than the yearly limit of $6,000.

Because there is no limit on the contributions you can make into a 401(K), the high-income taxpayer can deposit as much as they want, then rollover the entire balance.

Special Considerations for Backdoor Roth IRA’s

Taxpayers should crunch some numbers before diving into a Backdoor Roth IRA. If you converting a substantial amount of money from a Traditional IRA, the tax payable on the rollover might be a bit eye-watering.

Also, since the Tax Cuts and Jobs Act of 2017, you can no longer convert a Roth IRA back into a Traditional IRA.

You can Open a Joint Roth IRA with your Spouse

Another way high-income taxpayers can open a Roth IRA is by filing jointly with a spouse.

If you file jointly, the maximum annual gross income limit goes up to $206,000. That is $67,000 above the single filing limit.

Both members of the marriage combined must earn below $206,000 to become eligible.

Roth IRA Income Limits for 2020 Contributions

Either you are within the limits or not, you might have decided to open a joint Roth IRA with your spouse. But unless you have opted for the Backdoor Roth IRA, you must adhere to these limits:

Filing Status2020 Max Income LimitMax Annual Contribution
Single, or Married Filing SeparatelyLess than $124,000$6,000 ($7,000 for over 50s)
$124,000 – $139,000Contribution is reduced
$139,000 or MoreIneligible
Marries Filing JointlyLess than $196,000$6,000 ($7,000 for over 50s)
$196,000 – $206,000Contribution is reduced
$206,000 or MoreIneligible
Please check the IRS Website for more information

If you fall into the reduced contribution category, here is an example of a limit calculation:

If a person earns $134,000 per year. We subtract the Annual Gross Income limit from the earnings: $134,000 – $124,000 = $10,000

We then divide the result by $15,000: $10,000 ÷ $15,000 = 0.66

Then multiply this figure by the contribution limit of $6,000 ($7,000 if over 50): $6,000*0.66 ≈ $4,000

The amount this person would be able to contribute into the Roth IRA per year is $4,000.

Roth IRA Withdrawal Rules

With a Roth IRA you can withdraw your capital at anytime without penalty, but you cannot withdraw any earnings made in the account.

When withdrawing money before you reach the age of 60 you need to remember these 3 things:

  1. Your original contributions can be withdrawn without tax or penalty.
  2. When you withdraw funds, the IRS will assume you are taking original contributions first.
  3. Qualified withdrawals of earnings can come out tax free, this is either once the account holder reaches qualifying age, or the withdrawal is to purchase a first home.

The home purchase benefit allowed to Roth IRA holders allows them to make a 1-time withdrawal up to $10,000 to put towards the purchase of their first home.

Build Your Estate with a Roth IRA

There is no minimum distribution linked to a Roth IRA. A Traditional IRA is not like this, once you reach the age of 70, the IRS will start to withdraw funds from your account as tax payments on unpaid distributions.

Because you have already paid tax on the money in the Roth IRA, you do not need to draw distributions. This feature makes it fantastic for building your estate, or planning for future generations.

You can continue to contribute to your Roth IRA for as long as you are working, and you can leave the money in the account for long after you are dead.

Any unused money left in your account upon your death will be automatically passed down to your next of kin, this money will be tax free and without penalties. Your family then can draw the rest of the money, or continue to add to the balance.

I know the thought of retirement is boring to some people, so you can work until you’re 100 and the money in your Roth IRA will still grow, even if you’re not around anymore.

When Can I Contribute to my Roth IRA?

You can contribute to your account anytime from January 1st, to April 15th of the following year.

This gives you a 15 month period to make contributions. You can either do this at regular intervals, such as every month. Or make a lump sum deposit. As long as it’s less than $6,000 in total.

5 Key Benefits of Roth IRA’s

  1. Tax Free Income: All qualifying withdrawals from Roth IRA’s are tax free.
  2. Access to Contributions: You have complete access to contributions made in the account penalty free. You just can’t touch the earnings.
  3. Estate Planning: There is no regulation requiring you to withdraw from the account. You can pass down your entire account balance.
  4. High Income Loop-Hole: Even if you are a high income taxpayer, you can still reap the benefits of a Roth IRA.
  5. Home Purchase: If you are looking to purchase your first home, you can withdraw $10,000 worth of earnings from the account penalty free.

When Not To Open a Roth IRA?

There are very few circumstances in which I would say ‘do not open a Roth IRA’ but I will give some examples just incase you find yourself in one of these predicaments.

As mentioned, one of the best aspects of a Roth IRA is the tax free withdrawals you can make when you retire. But look at your current tax position, Traditional IRA’s and 401(K)’s act as write off’s in current tax years and you pay tax on the withdrawals.

The younger you are the more desirable a Roth IRA is. Think about this…

When you first enter the workplace, you are in a lower tax bracket and hence the tax write offs of pension payments are minimal.

You can invest post-tax income into a Roth IRA and let it grow tax free. Because the likelihood is, you’ll be in a higher tax bracket when you retire, so the tax free retirement income from your Roth IRA will come in hand.

The other side of this is if you are at the height of your career.

But if you are mid career or coming to the end of your work life, you are likely to be in the highest tax bracket of your life. This is where the tax breaks of Traditional IRA’s and 401(K)’s can be beneficial.

When you retire you will most likely go from the top of your earning potential to somewhere in the middle, so if you take advantage of the tax write offs when you’re at the top, it will increase your retirement pot, while saving you money on current tax bills.

The only sacrifice is a smaller tax payment on the withdrawals.

Heres a quick example:

If your annual income is $100,000 you are a 24% taxpayer, you can contribute to a Traditional IRA and reduce your taxable income, meaning you drop into the 22% tax bracket.

You are paying less tax now, and on a lower annual income.

Then when you retire you annual income from retirement savings in the Traditional IRA might be $80,000. Meaning you would remain in the 22% tax bracket. Saving you 2% of tax.

You have basically split your salary into two difference tax years to lower your overall tax bill.

This is a complicated tax calculation to complete. So if you are a high-income taxpayer, or near a tax bracket bridge consult a financial advisor. This could save you thousands of dollars over the course of your saving.

Who Offers the Best Roth IRA?

M1 Finance is my #1 pick for Roth IRA’s at the minute. They are passive, free, and easy to set up.

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You can choose what you want to invest in, how risky you are willing to go, and what target you want to aim for. Not only that, as far as I know, they are the only brokerage company to offer 100% free Roth IRA accounts.

You can check out my full review of M1 Finance here!

When you get to M1 Finance the minimum initial deposit is $500. To wave the initial deposit amount, signup through our Pain Free Investing exclusive link below.

Chris Race

I am an accountant from the U.K. specialising in Management Accounting, Personal & Business Tax, Financial Analysis, and Wealth Management. My passion for learning is what lead me to creating this blog. Stock market investing has always been a interest of mine, and since I was 18 years old... This interest has become a source of income for me and my family.

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