ROTH IRA Accounts Explained 2021

A ROTH IRA account is an individual retirement account that pays taxes when you pay into it so it can offer tax-free growth and tax-free withdrawals in retirement. ROTH IRA is named so after the creator, William Roth, a previous Delaware Senator. Usually, if you’ve owned a ROTH IRA account for over 5 years and are over 59 years old, you are able to withdraw your money without any taxes or fees.

An individual retirement account or IRA is a type of savings/investment vehicle that receives tax incentives from the US government and the IRS, in synthesis it allows individuals to either defer tax or benefit of tax-free capital gains from their investments.

In order to understand better what a ROTH IRA is, it is important to have an overall notional of what a Traditional IRA is and why it is key for individuals to take advantage of its benefits at an early stage in their life/career.

Just like with most investments, time will be an important factor for success and performance. Early investors usually receive a considerable advantage since earnings from contributions are reinvested into the account, resulting in a powerful compounding cycle. It’s easy how as the years go by the value of both an IRA  and ROTH IRA can grow exponentially.

While an IRA might not be enough for an individual to cover all of their retirement expenses, it offers space as a complementary model that also allows for savings and the ability to invest in the financial markets with a tax incentive that otherwise wouldn’t be possible. Most individuals commit the mistake of leaving their retirement plans for later in their life and this usually hinders their possibilities taking full advantage of a ROTH IRA.

In this article, we will cover the key differences and factors that differentiate a ROTH  IRA to any other type of IRA. Even though most types of IRAs offer a basic principle, it is important for individuals and investors to be aware that no two individuals are the same and this goes for ROTH IRA accounts too. Choosing an account can’t be taken lightly and requires for any individual to do their own research and analyze deeply their risk profile and also their taxes.

 

What are the Pros and Cons of a Roth IRA?

One of the best parts about a ROTH IRA is that even though the model of the account is not perfect, there are many different alternatives to choose from. If you take your time to review the different ROTH IRAs and you know what your necessities are, it is highly probable that you would end finding an option that will fit most your profile and your needs as an investor.

If we focus on the ROTH IRA alone, there are many advantages that can easily lure an investor into choosing it but once again and just like with any other investment vehicle, it is not perfect. Here are some of the most important pros and cons of choosing a ROTH IRA as your complementary retirement account:

 

What are the Limitations of a ROTH IRA?

Not every individual or married couple is eligible to start a ROTH IRA, this is due to a very strict limitation for individuals with a high annual income. Even though there are many limitations, the structure is pretty straightforward:

Please note that Filing status is the major denominator for these rules/limitations for opening a ROTH IRA.

1. Married filing jointly or qualifying widow(er)

• Less than $193,000 | Max contribution of $6,000 or 7,000 if 50+
• Between 193,000+  to $202,999 | Contribution is Reduced
• More than $203,000 | Not Eligible

2. Single, head of household or married filing separately

• Less than $122,000 | Max contribution of $6,000 or 7,000 if 50+
• Between 122,000+  to $136,999 | Contribution is Reduced
• More than $136,999| Not Eligible

3. Married Filing separately

• Less than $10,000 | Contribution is Reduced
• More than $10,000| Not Eligible

 

Define your Investment Style

One of the many questions I usually receive when talking to a new investor or someone who is starting to do their first steps in the financial markets is about which investment style is better? I usually like to answer by asking them back which style is better for who? Many individuals usually forget that before choosing an investment method or style it is important to understand your goals, risk appetite, and even your personality first.

Luckily for many, the financial markets offer a vast range of investment vehicles and assets to choose from, without any hesitation, I can say that there is an asset class for most individuals and that a style will depend on the risk aversion of the individual.

Without getting into the heavy detail about investment strategies and risk profiles, I recommend most individuals to decide between hands-on and hands-off styles respectively. Even though these two styles might seem too simple, in reality, the cover an important range of the market.

Hands Off

Not all individuals have the intention or the desire of spending hours doing research and reviewing their portfolios actively. It is actually pretty common to see investors looking for professional asset and fund managers to take control of their accounts in exchange for a percentage fee. While this might be a relatively expensive option, it offers a passive model that allows individuals to lay back a bit more.

Hands-On

Just like you can find individuals with no intention of participating actively, some others do not have what it takes to let a third-party manage their investments. This is a key point where personality is truly a show stopper for certain personalities and styles. Unless you are a professional trader or you have a vast knowledge and experience in the financial markets, you might be better off with an asset manager as it will take a lot of responsibility off your shoulders.

This model brings back the notional that a ROTH IRA is a retirement account, while the main goal many individuals have in mind is to profit, in reality, they should be a focus on capital conservation and saving as much for retirement as possible.

 

ROTH IRA vs. Traditional IRA Explained:

In a traditional IRA the tax incentive is, in reality, a tax deferral, this means that individuals would be able to defer their taxes until the funds are withdrawn from the account. With this model taxes will be paid based on the final funds, meaning that you would also be paying taxes over the contributed capital and any earnings incurred.

While this model benefited investors that later in their life would be in a lower tax bracket, it did the opposite for individuals whose bracket was higher.  In order to provide a relief mechanism and a fair ground for individuals that were suffering from this situation, the Taxpayer Relief Act of 1997 established the ROTH IRA.

The ROTH IRA is a newly created vehicle that offered individuals the ability to contribute after-tax money, this means that any contribution made to the account has already paid its due taxes. With this model, taxes were paid upfront instead of being deferred towards retirement. Another key element of a ROTH IRA is that any profit or earnings generated from investing the contributions and the balance of the account are tax-free.

Even though tax-free capital gains seem like a better option than deferring the tax, it is important to consider and keep in mind that the amount contributed which is technically the seed capital that will eventually be invested and compounded will be smaller and this can affect returns. It is not the same to invest $6,000 consistently and receive the return generated by the full six thousand, to paying taxes upfront and only investing  $4,000 after paying 25% on taxes.

To understand which one is the best option for an individual, it is necessary to understand and plan based on the overall picture and not just the ROTH IRA. In other words, investors should consider and run both scenarios and select the one that represents the best model in the long run.

At the end of the day, a ROTH IRA is supposed to be fully enjoyed at retirement, planning considering the time until retirement age is only appropriate in order to take full advantage and avoid expensive mistakes like choosing the wrong taxation model.

 

Best ROTH IRA Providers and Brokers of 2021

Continuing with the same structure, these are the best providers and brokers for a ROTH IRA in 2021. In order to provide better detail, we’ve separated the names between both hands-on and hands-off models.

Best ROTH IRA Accounts for Hands-On Investors:

 

Best ROTH IRA Accounts for Hands-Off Investors:

 

IRA Conversion

An IRA is a very dynamic type of account, to the point where individuals are allowed to convert their accounts between IRA Types. For instance, lets picture an individual with a Traditional IRA; after doing his own analysis he realizes that he should have open that account as a ROTH IRA instead many years back. In his current account, he has only deferred taxes, meaning that his contributions have not been taxed at all. In order for him to proceed with a conversion, he would have to pay the upfront taxes of his contributions to be able to switch to a ROTH IRA account. The amount to be paid will be calculated on the current tax rate of the individual.

This is the simplest model; you haven’t paid taxes and will have to pay them in order to do the conversion. On the other hand, if you are a ROTH IRA owner, and you would like to convert your account into a Traditional IRA, then it would be a different story. Under this model you have already paid taxes for your contributions, this means that you would be spending an account that will be taxed again later in the future.

In my experience, individuals usually commit the mistake of avoiding the tax talk or truly understand their tax situation going forward. But if you have made the right choice and you opened an IRA, it is key to see the big picture before many any decisions. At the end of the day, you don’t want to look back in the past and realize that the choice you made is costing you a significant amount in the future.

 

Conclusion

As mentioned before, there are not many reasons for an individual to pass on a ROTH IRA if they are eligible for one. If you choose the right investment vehicle your future self will truly appreciate the effort of saving and investing as the chances of improving your retirement increases dramatically.

Look at your ROTH IRA as a long term investment, it will help you avoid the temptation of early withdrawals and the boredom of watching paint dry. If you have the right approach it can become exciting to see how your contributions compound with the earnings and your money grow.

A ROTH IRA will be as good as your commitment to it and to your account selection. There are no perfect investment vehicles, but with enough research, it is easy to see which ones fit better to an individual’s profile and expectations.

Take your time understanding how your ROTH IRA works and specifically if that ROTH IRA account is what suits your needs better over a Traditional IRA.

 

Glossary of Investment Terms

FAQ