Contributing to a Roth IRA sets you up for tax-free investment growth and tax-free distributions in retirement. But not all workers qualify to make Roth IRA contributions, and some people prefer a more immediate tax break.
Here’s how to set up a Roth IRA:
1. Make sure you qualify for a Roth IRA.
2. Check the Roth IRA contribution limits.
3. Meet the Roth IRA contribution deadline.
4. Decide if the Roth IRA tax break is right for you.
5. Consider when you will need the money.
6. Explore where to open a Roth IRA.
A Roth IRA can be used to lower your lifetime tax bill. Here’s how a Roth IRA will help you prepare for retirement.
1. Make Sure You Qualify for a Roth IRA
You must have earned income in order to make a Roth IRA deposit. Workers with high salaries aren’t eligible to contribute to Roth IRAs. Roth IRA eligibility is phased out for people who earn more than $129,000 ($204,000 for married couples) in 2022. Workers who earn more than $144,000 ($214,000 for couples) can’t directly contribute to a Roth IRA in 2022.
However, those with high incomes may still be able to convert traditional IRA assets to a Roth IRA, but they must pay income tax on the amount converted. “Folks who make a high income over those limits, if they want to contribute to a Roth IRA, you can do a backdoor Roth conversion,” says Martin Lundgren, a certified financial planner and president of Northern Lights Advisors in Seattle.
2. Check the Roth IRA Contribution Limits
Workers age 49 and younger can contribute up to $6,000 to a Roth IRA in 2022. Those age 50 and older can make an additional $1,000 catch-up contribution for a maximum possible Roth IRA deposit of $7,000. If you exceed these Roth IRA contribution limits, you will trigger a 6% excise tax on the additional contributions. Take care to withdraw any excess contributions before the due date of your tax return to avoid the penalty.
3. Meet the Roth IRA Contribution Deadline
Roth IRA contributions are due by your tax filing deadline, which is typically around April 15 each year. If you make a contribution between January and April, you will need to specify whether the deposit should be applied to the current calendar year or the previous tax year.
[Read: A Guide to Your IRA.]
4. Decide if the Roth IRA Tax Break is Right for You
Unlike traditional IRAs, Roth IRAs don’t provide a tax deduction in the year you contribute to the account. However, you don’t have to pay tax on the annual investment growth while your money is in the account. Withdrawals after age 59 1/2 from accounts that are at least five years old are tax-free.
“Roths are funded with post-tax money that you have already paid tax on today, so you will not have to pay tax on it again in the future,” says Alex Doll, a certified financial planner and president of Anfield Wealth Management in Cleveland.
To decide between a traditional and Roth IRA, compare your current tax rate to the rate you expect to pay in retirement. A Roth IRA allows you to lock in your current tax rate and avoid future taxes on your retirement savings.
“If you believe you are in a higher tax bracket now than you will be when you take the money out of your IRA, you should use a traditional IRA,” Doll says. “And if you think you are in a lower tax bracket today than you would be in the future, you should use a Roth IRA.”
Roth IRAs are an especially good deal for young people with low starting salaries who have decades for the account balance to grow. “Usually when you start your career, your income is lower, and so is your tax bracket,” says Luiz Augusto Pacheco, a certified financial planner at Brainvest Wealth Management in Miami. “So, it would be better to go the Roth route and take benefit of that.”
5. Consider When You Will Need the Money
While annual withdrawals from traditional IRAs are required after age 72, there are no distribution requirements for Roth IRAs during the original account owner’s lifetime, so you can leave the money to grow tax-free in the account until you need it.
“When you take that money out in retirement, it has already been taxed and it doesn’t add to your taxable income at all,” Lundgren says. “If you really don’t need the Roth IRA assets in your lifetime, they can be inherited.” If you leave money in a Roth IRA to heirs, your beneficiaries may also be able to take tax-free distributions from the account.
Roth IRAs have fewer taxes and penalties than traditional IRAs if you need access to your retirement savings before age 59 1/2. You can withdraw money that you contributed to your Roth IRA without penalty if the account is at least five years old. The 10% penalty on early withdrawals applies to distributions of investment earnings, unless you use the money for specific purposes.
“You can tap the earnings penalty-free for a future home purchase, higher education expenses for you or a family member or health insurance premiums while you are unemployed,” says Justin Porter, a certified financial planner and founder of Porter Wealth Management in Atlanta. “You just need to have the account open for five years in order to qualify for penalty-free distributions of contributions. I recommend opening the account as early as possible to start the five-year clock, even if that means funding it with a nominal amount in the first year.”
6. Explore Where to Open a Roth IRA
Roth IRAs can be opened at most banks and financial institutions. Take care to compare several providers before funding an account. Look for the investment options you want and reasonable fees.
“The lowest-cost option typically requires you to manage the portfolio yourself,” Doll says. “In that case, I recommend they go directly to a big firm that offers low-cost index funds with commission-free trades, such as Schwab, Fidelity, Vanguard or TD Ameritrade.” Those who need additional help selecting investments can consult with a financial planner or use a robo advisor for an additional fee.
More from U.S. News
Update 12/21/21: This story was published at an earlier date and has been updated with new information.