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What Is a Roth IRA?

A Roth IRA is an individual retirement account funded with after-tax dollars. You can’t deduct contributions to a Roth IRA at tax time, but you can withdraw your money tax-free in retirement. A Roth IRA is a popular choice for young people just starting out in their careers. Want to know more about this retirement strategy? You’ve come to the right place. We’ll give you the run-down.

Check out our retirement calculator.

Roth IRA Pros and Cons

These days, people who want to save for retirement have many choices as to where they park their dollars. One popular retirement investment vehicle is the Roth IRA. You fund a Roth IRA with after-tax dollars and don’t deduct your contributions when you file your tax returns. That’s good news and bad news, depending on how you look at it. The bad news is that you don’t get a tax break now. The good news is that you get a more valuable tax break down the road (aka after you turn 59 1/2). Why? Because you won’t have to pay income tax on either the money you originally contributed or the money you’ve earned over years in the market.

The younger you are, the more you stand to gain from opening a Roth as part of your retirement savings plan. Any money you contribute now will have more years of compounding and growth. That means you’re getting a bigger tax break when you start taking distributions in retirement than you would if you opened a Roth at age 50.

Another advantage of the Roth is that it doesn’t come with Required Minimum Distributions (RMD)s while the owner of the account is alive. That means you don’t have to start taking money out of your Roth IRA when you hit age 70 1/2, as you would with a traditional IRA.

Depending on your circumstances, the lack of RMDs could be a big advantage. If you’re already getting enough income from a combination of Social Security and a 401(k), having a regular IRA would require you to take distributions that could push you into a bigger tax bracket. With a Roth IRA, you won’t run into the problem of having to take money you don’t need only to be slammed with a bigger tax bill.

Related Article: Roth vs. Traditional IRAs

Roth IRA Eligibility

What Is a Roth IRA?

Roth IRAs were not designed for wealthy savers. In fact, there is an income cap on Roth IRA eligibility. The IRS income rules for Roth IRAs use your Adjusted Gross Income (AGI) as a guide. Your AGI is simply the total of all your taxable income, minus certain qualified deductions such as those for medical expenses and unreimbursed business expenses.

The IRS sets an income eligibility range that tells you whether you can make a) the maximum contribution to a Roth IRA ($5,500 for tax year 2016), b) a partial contribution or c) no contribution. This year, the AGI phase-out range for a married couple filing jointly is $184,000-$194,000. For those filing singly, the range is $117,000 to $132,000.

If your income falls below the bottom of the range, you can contribute the full $5,500 to a Roth IRA. If it’s within the range, you are subject to contribution phase-out rules, meaning that you won’t be able to contribute the full $5,500. If your income is above the top of the phase-out range, IRS rules prohibit you from contributing to a Roth IRA.

The Backdoor Roth

Too rich for a Roth? There’s a workaround called the “backdoor Roth” that lets you take advantage of the tax benefits of a Roth IRA. Say you’re doing well for yourself financially. You have a 401(k) through your employer, but you’re hankering after a Roth so you can diversify your tax burden in retirement. If your income means you’re ineligible to open a Roth directly, you can still open a backdoor Roth.

Related Article: What Is a Non-Deductible IRA?

If you’re in a high income bracket and saving through your 401(k) at work, you won’t be able to fund a deductible traditional IRA. But you can still open a non-deductible traditional IRA and then convert that traditional IRA to a Roth IRA. And just like that, you have a Roth. Sneaky, right?

If you want to take advantage of a backdoor Roth, act fast. The government has its eye on the backdoor Roth as one of several tax loopholes to close. The backdoor Roth is popular, so it may survive efforts to eliminate it.

Related Article: Which Type of IRA Is Right for You?

The Takeaway

What Is a Roth IRA?

Having a Roth IRA in your financial arsenal gives you more flexibility in retirement. You don’t have to take (and pay taxes on) Required Minimum Distributions if you don’t want to. And did we mention that any money you do take out of your Roth IRA  (that is a qualified distribution) is completely free from federal taxes?

Are you tempted? If so, look for a Roth IRA provider offering low fees. Higher fees mean less money for you and more money for the financial institution hosting your investments. Fees can cost investors tens of thousands of dollars over the course of their working years, so it pays to shop around and get the best deal you can. Happy saving!

Photo credit: flickr, ©iStock.com/gpointstudio, ©iStock.com/Milan Marjanovic

Amelia Josephson Amelia Josephson is a staff writer covering financial literacy topics at SmartAsset. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.

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