Types of Retirement Accounts: Roth IRA

Retirement. Roth IRA. It’s something that most of us don’t think we need to worry about until we get older. Retirement is also something that most of us don’t think we can worry about right now. After all, we have student loans, expensive healthcare costs, rising housing prices, kid’s college, aging parents, and a host of other financial worries that usually push the idea of retirement to the back of our mind. Additionally, retirement can be overwhelming. Most people have no idea what to invest in, how the investing process works, what tax implications our decisions may have, and most of all; how much money do you need to retire.

While all of these questions will be answered in future articles, this article will start on the ground floor with the question: What are the different types of retirement plans? There are several different types of retirement plans and in this article, we will be addressing #2, Roth IRAs. These articles will give you an idea of what to look for when deciding on how to save for retirement and what type(s) of retirement accounts to save in.

Types of Retirement Plans

1. Traditional IRA
2. Roth IRA (this article)
3. 401(k)
4. 403(b)
5. SIMPLE IRA
6. Simplified Employee Pension (SEP)
7. Salary Reduction Simplified Employee Pension Plan (SARSEP)
8. Payroll Deduction IRA
9. Profit-Sharing Plan
10. Defined Benefit Plan
11. Money Purchase Plan
12. Employee Stock Ownership Plan (ESOP)
13. Thrift Savings Plan (TSP)
14. 457 Plan

IMPORTANT: READ THIS BEFORE CONTINUING

Before we get into the types of retirement accounts, it is important to make one key distinction. A retirement account, itself, is not an investment. If you say something to the extent of, “My 401(k) hasn’t done very well this past year and I’m thinking of picking a different one” you would be making an incorrect statement.

Think of it like this: There are 14 different types of retirement accounts (we will discuss the other 13 in different articles). Each one of those retirement accounts should be thought of as a cooking pot. If you cook something in that pot and you don’t like what it tastes like, you don’t dump the contents into another pot and hope that it tastes better. You change the ingredients of that pot to something else. Now think of the ingredients as different investment products (stocks, bonds, cash, mutual funds, and/or a host of other products/ingredients).To get the taste you want, you change the ingredients, not the pot. You may be wondering, what ingredients do I put into my pot? That is a fair question, but you cannot answer that question until you figure out what pot is best for you. Now buckle up and find out what the 14 different types of retirement accounts (pots) you have at your disposal.

Credit: Nicholas Gras: https://unsplash.com/@armgd

(2) Roth Individual Retirement Arrangement (Roth IRA)

First, let me start out by saying that a Roth IRA is one of my favorite overall retirement accounts. And unless you get a match on your 401(k) or 403(b) (and even if you are), you should be contributing to a Roth IRA. The one thing to remember that differentiates Roth IRAs from other investment products is that with a Roth IRA, you pay taxes on the seed, not the harvest. This will make more sense soon.

A Roth IRA is named after the US Congressman, William Roth, who helped sponsor this version of an IRA that became a law in 1998.

A Roth IRA works very similarly to a traditional IRA with one key difference. The difference being that when you put money into a Roth IRA, it is done post-tax. Let me explain how this works. But in order to properly explain this you must remember Rule #1.

Rule #1: Whenever you make money, you MUST pay taxes on that money SOMETIME.

When you go to work and earn money, you have to pay taxes. We all pay federal income taxes, most of us pay state income taxes, and some of us pay local income taxes (city and/or county). We also pay payroll taxes but those are not important in this discussion. Also, taken out of our paycheck might be things like health insurance, life insurance, and (hopefully) retirement contributions. The question is, in what order are these items taken out of your paycheck (because it makes a big difference).

Alright. Now that you know Rule #1, I can explain how taxes on retirement income work. Let’s start with a traditional IRA and then compare it to a Roth IRA so that you can see the difference.

Our friend Chuck works at the local fire department and makes $4,000 every month (this is referred to as his gross income). He has to pay federal income tax of 20%, state income tax of 5%, and no local income taxes. He also wants to put 15% of his income into a pre-tax (such as a traditional IRA or a 401(k)) retirement plan. This means that he pays $800 in federal income tax, $200 in state income tax, and he puts $600 into his pre-tax retirement account leaving him with $2,400 left over to be deposited into his bank account (net income). Here’s a chart to better see how it works:

Chuck’s Income

Gross Income	$4,000
Federal Income Tax (20%)	$800
State Income Tax (5%)	$200
Traditional IRA Contributions (15%)	$600
Net Income	$2,400

It is important to note that the traditional IRA contributions that Chuck made were based on his gross wages. This means that he has not yet paid taxes on this money. And remember:

Rule #1: Whenever you make money, you MUST pay taxes on that money SOMETIME.

This means that Chuck still owes taxes on the $600 that went into his traditional IRA. When will he have to pay it? When he takes the money home to live on when he retires. This means that this money can grow tax-deferred (meaning that Chuck has deferred paying the taxes) until retirement.

Now let’s consider Larry. Larry works at the same fire station, makes the same income, pays the same taxes, and contributes the same amount as Chuck. The only difference is that Larry contributes 15% of his income into a Roth IRA. This means that he is using after-tax dollars. Here is a chart to see how Larry’s income looks:

Larry’s Income

Gross Income	$4,000
Federal Income Tax (20%)	$800
State Income Tax (5%)	$200
After-Tax Income	$3,000
Roth IRA Contributions (15%)	$600
Net Income	$2,400

I hope you noticed that at the end of the day, both Chuck and Larry had the same net income ($2,400). So what is the difference between the traditional IRA and the Roth IRA if they both have the same net income? The difference is that with the Roth IRA, Larry has already paid taxes on that money. While with the traditional IRA, Chuck will have to pay taxes on it later. 

So let’s assume that (1) taxes were to remain the same throughout Chuck and Larry’s lifetime, (2) they both invest the same amount, (3) they both earn the same return on their investments, and (4) they both retire at the same time they should have the same amount of money. But Chuck will still owe taxes on that money, while Larry won’t. And the more money someone invests, they more they will owe on taxes because of Rule #1.

Rule #1: Whenever you make money, you MUST pay taxes on that money SOMETIME.

Because I like making charts, here is a chart on how the benefits of the Roth IRA compound over time:

	Chuck’s Traditional IRA	Larry’s Roth IRA
Amount After 1 Year	$4,000	$4,000
Taxes (25%)	($1,000)	($0)
Net Amount	$3,000	$4,000

	Chuck’s Traditional IRA	Larry’s Roth IRA
Amount After 5 Years	$20,000	$20,000
Taxes (25%)	($5,000)	($0)
Net Amount	$15,000	$20,000

	Chucks Traditional IRA	Larry’s Roth IRA
Amount After 10 Years	$40,000	$40,000
Taxes (25%)	($10,000)	($0)
Net Amount	$30,000	$40,000

	Chuck’s Traditional IRA	Larry’s Roth IRA
Amount After 20 Years	$80,000	$80,000
Taxes (25%)	($20,000)	($0)
Net Amount	$60,000	$80,000

The way that Roth IRAs are treated by the IRS is the most important part in understanding the benefits of them and now that you hopefully understand that, it is important to know what can and cannot be put into a Roth IRA.

Within a Roth IRA you can have many different investment vehicles such as:

1. Stocks
2. Bonds
3. Mutual funds
4. Unit investment trusts
5. Government securities (Treasury bills, treasury notes, and treasury bonds)
6. US government-issued gold and silver coins. 

If you don’t know what all of these different terms mean, that is perfectly fine. Just know that you can have nearly all investment vehicles within an IRA.

But, there are a few items that cannot be in a Roth IRA. Roth IRAs cannot have:

1. Antiques
2. Gems
3. Rare coins
4. Works of art
5. Life insurance contracts: This is because life insurance contracts are not securities (investments).
6. Municipal bonds: This is because putting a municipal bond in an IRA would negate the tax free status of the municipal bond.

Antiques, gems, rare coins, and works of art cannot be included in Roth IRAs because these items do not have a solid market value. Meaning: I might be willing to pay $50,000 for a painting, but you may be willing to only pay $3,000 for the same painting. It is too difficult to find an agreeable market value.

There are some stipulations to having a Roth IIRA that are important to know.

1. Contribution Limits (as of 2021): You can contribute up to $6,000/year unless you are 50 years old or older, at which time you can contribute $7,000/year. This is known as the “catch-up” contribution. It is meant to help people who are a little bit older put more money in their retirement account because they have less time before retirement. The catch-up contribution can start to be made the year that you turn 50. So if your birthday is in September, you can contribute the full $7,000 starting in January of that year even though you are only 49.

Age	Maximum Contribution
Less than 50	$6,000
50 (the year you turn 50)	$7,000
Older than 50	$7,000

The  second contribution limitation is based on your earned income. Someone investing in a traditional IRA cannot contribute more than their earned income. For example, if you earned $3,000 you cannot contribute more than $3,000. The word “earned” is important for this discussion. Earned income is based on money that you (you guessed it) earned. This is nearly always from salary, wages, tips, bonuses, self-employment income, or farm income. Earned income is not from:

1. Child support
2. Rental property income
3. Interest and dividend income
4. Income while incarcerated
5. Retirement income
6. Social Security
7. Unemployment benefits
8. Alimony (Although this one is tricky because the laws have changed regarding this. Check with a CPA to make sure.)

Age	Income	Maximum Contribution
Less than 50	Less than $6,000	Amount of earned income
Less than 50	$6,000	$6,000
Less than 50	More than $6,000	$6,000
50 or older	Less than $7,000	Amount of earned income
50 or older	$7,000	$7,000
50 or older	More than $7,000	$7,000

The third contribution limitation for the Roth IRA is also based on your income. There are income limits to investing in a Roth IRA. If you file your taxes using the Married Filing Jointly (MFJ) designation, the IRS starts to phase out what you can contribute to a Roth IRA at $198,000 and you would no longer be able to invest in a Roth IRA once you make $208,000. If you are a single taxfiler, the phaseout income amount starts at $125,000 and the maximum income is $140,000. Here is a chart to better see it:

Tax Filing Status	Income	Contribution Limit
MFJ	<$198,000	$6,000 or $7,000 (Depending on age)
MFJ	>$198,000 but <$208,000	A reduced amount
MFJ	>$208,000	$0
Single	<$125,000	$6,000 or $7,000 (Depending on age)
Single	>$125,000 but <$140,000	A reduced amount
Single	>$140,000	$0

If you make more than those amounts you can still open up a “backdoor Roth IRA”. How this is done is a bit technical and outside the scope of this article. If you talk to a CPA or financial advisor, they can help you out.

2. Contribution Deductions (as of 2021): This is one of the biggest differences between a traditional IRA and a Roth IRA. With a traditional IRA, unless you make too much money, you can deduct the amount that you contributed to it off of your taxes. This is a nice little bonus. But with a Roth IRA you cannot do that because you are paying taxes up front on the money that you put into the Roth IRA (rather than deferring the taxes as you would in a traditional IRA). Think of it like this: Would the IRS let you (1) pay taxes on monies that you earned AND (2) deduct the money that you paid in taxes? The answer is no. The IRS will let you do one or the other, but not both. 

3. Early Withdrawal (as of 2021): You should never take money out of a Roth IRA until you are at least 59 ½. This is the most important consideration of a Roth IRA (and any retirement account for that matter). This money is not there for you to buy a boat or go on a vacation, it is to retire with. If you take money out of a Roth IRA before age 59 ½ you will pay a penalty of 10%. You may be asking, “What about taxes? I don’t have to pay taxes? Just a penalty?” The answer is no. That is because you already paid taxes on the money when you first put it into the Roth IRA. However, there are a few exceptions to the early withdrawal penalty:

1. Death: Your heirs can take the money, not you, you’re dead.
2. Disability: If you become permanently disabled, you can withdraw from your traditional IRA without penalty (although you will still have to pay the appropriate taxes).
3. Home purchase: You can withdraw up to $10,000 from a traditional IRA for the purchase of your first home (primary residence) without penalty (although you will still have to pay the appropriate taxes).
4. Higher education expenses: This would be paying for college, community college, or technical school for yourself, your spouse, your child, or grandchild. 
5. Medial premiums during unemployment: You can withdraw the amount of health insurance premiums during the time that you are unemployed without penalty (although you will still have to pay the appropriate taxes.)
6. Unreimbursed medical expenses: You can withdraw the amount needed to pay any medical expenses that have not (and likely will not) be reimbursed by another party without penalty. But once again, you will still have to pay taxes on this amount.
7. Qualified disaster distributions: If you receive “substantially equal periodic payments” when you have been the victim of a qualified disaster you will not be subject to the 10% penalty so long as the distributions do not exceed $100,000.

4. Required Minimum Distributions (as of 2021): Different than the traditional IRA, a Roth IRA does not have required minimum distributions (RMDs). When you reach retirement age, if you don’t need the money, you can let it sit in the account as long as you want, even until your death. At that point, your Roth IRA will pass to your estate and/or your heirs.

(2a) Spousal Roth IRA

A spousal Roth IRA works the same as a regular Roth IRA but is meant for a spouse who does not have an income. By definition, a spousal IRA is just an IRA for a spouse. If you file your taxes as Married Filing Jointly (MFJ), and one spouse does not have an income but the spouse does, then the non-working spouse can still open a spousal Roth IRA.

Spousal IRAs were first started to help protect wives. In the past, it was very common for a wife to stay at home and raise the children. It was not uncommon for a wife to not have credit cards, personal loans, mortgages, or retirement accounts. This was a huge problem because if the husband were to pass away or the couple were to divorce, the wife would have no credit, likely no job history, and no retirement income. Although times have changed, and this scenario is far less common than it was 40 years ago, there are still lots of spouses that do not work outside the home and have no retirement accounts in their name.

If you want to open a spousal Roth IRA, you must meet these qualifications:

1. File your taxes with the Married FIling Jointly (MFJ) designation
2. Adhere to the same limits, rules, and regulations of a Roth IRA (as stated earlier in this article)
3. Not contribute more than the earned income of the working spouse

Here is an example of how much can be contributed to both a traditional IRA and spousal IRA in a given year, provided the couple is filing MFJ:

Age	Spouse #1 Income	Spouse #2 Income	Traditional IRA Limit	Spousal IRA Limit	Total IRA Contribution Limit
Less than 50	$6,000	$0	$6,000	$6,000	$6,000 (split between both IRAs)
Less than 50	$20,000	$0	$6,000	$6,000	$12,000
50 or older	$7,000	$0	$7,000	$7,000	$7,000 (split between both IRAs)
50 or older	$20,000	$0	$7,000	$7,000	$14,000

I know that this is a lot of information but it is important to know what a Roth IRA is, if it is appropriate for your situation, and how it can help you. You don’t necessarily have to understand the entire IRS rulebook regarding Roth IRAs, but I hope that you now have a better understanding of how they work. The most important thing to remember is that with a Roth, you pay taxes on the seed, not the harvest. This is just one more way that you can exercise your Money Muscle and become a little more financially fit.