How To Start A Roth IRA Account: A Complete Guide For 2022

A Roth IRA is an individual retirement account (IRA) that allows for tax-free withdrawals if certain conditions are met. It was founded in 1997 and is named for William Roth, a former Delaware senator.

Roth IRAs are very similar to standard IRAs, with the only difference being taxed. Because Roth IRAs are funded with after-tax funds, donations are not tax-deductible. However, once you begin withdrawing funds, they are tax-free. On the other hand, traditional IRA contributions are typically made using pretax cash; you will normally receive a tax deduction for your contribution and will pay income tax when you withdraw the money from the account after retirement.

This and other key differences make Roth IRAs a better choice than traditional IRAs for some retirement savers. If you’re still not familiar with Roth IRA, let’s delve a little deeper and learn more about it.

Understanding Roth IRAs

The money invested in a Roth IRA grows tax-free, just like it does in other eligible retirement plan accounts. A Roth IRA, on the other hand, has fewer restrictions than other types of IRAs. The account holder can keep the Roth IRA permanently; unlike 401(k)s and traditional IRAs, there are no required minimum distributions (RMDs) during their lifetime.

A Roth IRA can be funded from a number of sources:

• Regular contributions
• Spousal IRA contributions
• Transfer
• Rollover contributions
• Conversions

All regular Roth IRA contributions must be made in cash (including checks and money orders); no stocks or property can be used. Once monies are deposited to a Roth IRA, however, a range of investment options are available, including mutual funds, equities, bonds, exchange-traded funds (ETFs), certificates of deposit (CDs), and money market funds. The Internal Revenue Service (IRS) sets a limit on how much money can be put into each form of IRA and adjusts it on a regular basis. Traditional and Roth IRA contribution limitations are the same.

Opening a Roth IRA

A Roth IRA must be opened with a financial institution that has been approved by the IRS to offer IRAs. Banks, brokerage firms, federally insured credit unions, and savings and loan associations are among them. Individuals typically open IRAs through brokers. A Roth IRA can be opened at any time. Contributions for a tax year, on the other hand, must be made by the IRA owner’s tax-filing date, which is usually April 15 of the following year. Extensions for submitting taxes do not apply.

Two basic documents must be provided to the IRA owner when an IRA is established:

• The IRA disclosure statement
• The IRA adoption agreement and plan document

These documents explain the laws and regulations that apply to the Roth IRA and constitute a contract between the IRA owner and the IRA custodian/trustee.

Financial institutions are not all created equal. Some IRA providers offer a wide range of investment alternatives, but others are more limited. For your Roth IRA, almost every institution has a distinct fee structure, which can have a big impact on your investment returns.

When it comes to choosing a Roth IRA provider, your risk tolerance and investment preferences will play a role. If you intend to be an active investor who makes a lot of transactions, you should look for a provider with cheaper trading expenses. If you leave your investments alone for too long, some providers will charge you an account inactivity fee. Some providers provide a wider range of stocks or ETFs than others; it all depends on the assets you desire in your account.

Pay close attention to the account’s specific criteria as well. The minimum account balances for some providers are higher than for others. Check to see whether your Roth IRA account comes with extra banking products if you plan on banking with the same organization.

Whether you want to start a Roth IRA with a bank or brokerage where you already have an account, check to see if you qualify for any IRA fee discounts.

5 Steps to opening a Roth IRA

1. Make sure you’re eligible.

As long as they have earned income for the year, most people are eligible to contribute to a Roth IRA. Keep in mind that there are income limits based on your modified adjusted gross income (MAGI) if you’re thinking about donating to one:

• For the 2021 tax year, an individual’s capacity to contribute to a Roth IRA begins to dwindle at $125,000 and then completely ends at $140,000. Couples’ contributions are halved starting at $198,000 and gradually tapered out at $208,000.
• For the 2022 tax year, an individual’s phaseout range is $129,000 to $144,000. It ranges from $204,000 to $214,000 for couples.

There are also limits to the maximum amount you can invest in a Roth IRA each year:

• You can contribute $6,000 to an IRA in 2021 and 2022, plus an additional $1,000 if you are 50 or older. The total limit remains the same if you have more than one IRA, such as a standard tax-deferred account and a Roth account.

If you need to reduce your contribution, you can use our Roth IRA calculator to determine the correct amount.

2. Decide where to open your Roth IRA account

You can contribute $6,000 to an IRA in 2021 and 2022, plus an additional $1,000 if you are 50 or older. The total limit remains the same if you have more than one IRA, such as a standard tax-deferred account and a Roth account.

Ask these questions as you decide where to open the account:

• Is there a fee to open or maintain it?
• Does the company provide customer service online or by telephone?
• Does the company offer the types of investments you’re looking for, whether that means exchange-traded funds (ETFs), target-date funds, actively managed funds, or stocks and bonds?
• How much does it cost to trade? This is especially important if you plan to buy and sell frequently in your account.

3. Fill out the paperwork

Most banks and brokerages have Roth IRA web pages where you may start the process. You may be able to complete the entire application online, or if you have any issues, you can contact customer care.

You’ll need the following:

• A driver’s license or another form of photo identification
• Your Social Security number (SSN)
• Your bank’s routing number, and your checking or savings account number so that you can transfer money directly to your new account
• The name and address of your employer
• The name, address, and SSN of your plan beneficiary (the person who will get the money in the account if you die)

It is critical to name one or more beneficiaries. It enables the account to be passed on to someone else without the need for probate. Remember to update your beneficiary designation after major life events such as marriage, divorce, or a beneficiary’s death. You will be required to complete a 5305-R form for the Internal Revenue Service as part of the application process (IRS).

4. Choose investments

The financial business will assist you in opening the account, but you must determine how you will invest the funds in your Roth. Starting a Roth IRA can be the most challenging step.

There are three basic approaches to choosing investments for your Roth IRA.

• Choose from a variety of options available at most financial institutions to create your own portfolio.
• Invest in a life-cycle or target-date fund. It’s similar to a ready-made portfolio for someone your age created by an investment firm for someone your age.
• Consult a financial counselor, either one affiliated with that financial institution or one who is independent.

Below are some considerations about each of these choices.

Design your own portfolio

If you’re going to build your own Roth IRA investment portfolio, it’s critical to choose investments depending on your degree of comfort and retirement time horizon. Bonds are more stable than stocks, therefore many people spend more of their money in them as they get older. Stocks, on the other hand, stocks have traditionally provided larger long-term returns, so there is a tradeoff.

Even as you get older, new rules of thumb advocate keeping a large chunk of your portfolio inequities. This is due to the fact that people are living longer, have lesser retirement savings, and may incur higher medical costs.

Many experts advocate investing in two to six mutual funds or exchange-traded funds (ETFs)—some of which are made up of stocks, while others are made up of bonds—and keeping a modest portion of your account in cash or cash equivalents, such as money market funds. Invest in funds with expense ratios of less than 0.5 percent. This fee is in addition to any account-related fees you may be charged by your bank or brokerage.

Buy a target-date or life-cycle fund

These funds, which are made up of a combination of stocks and bonds, are designed to automatically adapt over time as you near retirement age, moving to safer investing options. Fidelity’s Freedom Funds and Vanguard’s Target Retirement Funds are two examples of well-known fund families.

When purchasing a target-date fund, keep in mind that it is intended to serve as your whole retirement portfolio. It’s ideal if you only get one. Also, keep in mind that the fees charged by these funds may be higher than those charged by other investments due to the management involved.

Consult an advisor

Some consumers opt to engage an advisor to assist them to choose investments for their Roth IRA accounts, such as a fee-only financial planner. Others rely on the firm that manages their account for free or for a fee for advice. In any case, make sure to ask questions, so you know exactly what you’re getting and whether it’s suitable for your objectives.

5. Set up a contribution schedule

You can set up monthly transfers from your bank account to your Roth IRA if your bank allows it. Alternatively, as long as you fulfill the income requirements, you can choose to make an annual donation. You can contribute to your Roth IRA until the following year’s tax filing deadline, which is usually April 15.

Remember that Roth IRA contributions are made using after-tax funds, so there’s no benefit to deferring your contribution until the last minute. In fact, the sooner you donate, the sooner your money will start working for you.

After you’ve opened your account

At least once a year, examine your regular account statements and take the time to carefully reevaluate your investment decisions. To rebalance your account, you may choose to buy and sell investments at that time.

The value of your investments will fluctuate over time as markets rise and fall. Let’s imagine you started the year with a 30 percent bond fund and 70 percent stock fund portfolio. It’s possible that your portfolio has moved by the end of the year. If equities have lost value, the portfolio may now be made up of 40% bonds and 60% stocks. You could choose to sell some bond fund shares and use the money to buy more stock fund shares in this situation.

The more investments you possess, the more difficult it will be to rebalance. When you rebalance to raise the share of less-volatile fixed-income assets like bonds as you get closer to retirement, this becomes more significant. You don’t need to worry about rebalancing if you have a target-date fund, but it’s still a good idea to keep an eye on your account.

Are Roth IRAs insured?

If you have an account with a bank, keep in mind that IRAs are insured differently from traditional deposit accounts. As a result, IRA account coverage isn’t as comprehensive. The Federal Deposit Insurance Corporation (FDIC) still insures traditional, and Roth IRA accounts up to $250,000, but account balances are aggregated rather than being evaluated separately.

For example, if the same banking client has a CD for $200,000 stored in a traditional IRA and a Roth IRA at $100,000 maintained in a savings account worth $100,000 at the same institution, the account holder has $50,000 in unprotected assets.

What can you contribute to a Roth IRA?

The IRS regulates not only the amount of money you can put into a Roth IRA but also the type of money you can put into one. In general, a Roth IRA can only be funded with earned money.

Wages, salaries, commissions, bonuses, and other amounts given to an employee that are eligible to finance a Roth IRA include wages, salaries, commissions, bonuses, and other amounts provided to the employee for services rendered. It’s usually any amount listed in Box 1 of a person’s Form W-2.

Compensation for a self-employed person or a partner or member of a pass-through business is equal to the individual’s net earnings from their business, less any deductions allowed for contributions made on the individual’s behalf to retirement plans, and further reduced by half of the individual’s self-employment taxes.

Money from a divorce—alimony, child support, or a settlement—can also be contributed if it is connected to taxable alimony received prior to Dec. 31, 2018.

So, what sort of funds aren’t eligible? The list includes:

• Rental income or other profits from property maintenance
• Interest income
• Pension or annuity income
• Stock dividends and capital gains
• Passive income earned from a partnership in which you do not provide substantial services

You can never put more money into your IRA than you make in a given tax year. And, as previously stated, you will not receive a tax deduction for the contribution—although, depending on your income and life situation, you may be eligible for a Saver’s Tax Credit of 10%, 20%, or 50% of the deposit.

The spousal Roth IRA

The Spousal Roth IRA is one way for a spouse to increase their contributions. A person can contribute to a Roth IRA on behalf of their married partner who has a low or no income. The same requirements and limits apply to spousal Roth IRA contributions as they do to normal Roth IRA contributions. Because Roth IRAs cannot be joint accounts, the spousal Roth IRA is kept separate from the Roth IRA of the individual making the contribution.

To be eligible for a spousal Roth IRA contribution, an individual must meet the following criteria:

• The pair must be married and submit a joint tax return in order to qualify.
• The spousal Roth IRA contribution must be made by someone who is eligible for it.
• The sum of both spouses’ contributions cannot exceed the taxable compensation stated on their combined tax return.
• Contributions to a single Roth IRA cannot exceed the IRA’s contribution restrictions (however, the two accounts allow the family to double their annual savings).

Withdrawals: qualified distributions

You can take tax-free and penalty-free withdrawals from your Roth IRA at any time. If you withdraw simply the amount you put in, regardless of your age or how long it has been in the account, the distribution is not deemed taxable income and is not subject to penalty.

When it comes to withdrawing account earnings, there is a catch: any returns that the account has generated. To be considered a qualified distribution, account earnings must be distributed at least five years after the Roth IRA owner established and financed their first Roth IRA, and the distribution must meet at least one of the following criteria:

• When the payout occurs, the Roth IRA bearer must be at least 5912 years old.
• The Roth IRA holder or a qualified family member (the IRA owner’s spouse, a child of the IRA owner or of the IRA owner’s spouse, a grandchild of the IRA owner and/or of their spouse, or a parent or other ancestor of the IRA owner or of their spouse) uses the distributed assets to buy—or build or rebuild—their first home. This is capped at $10,000 per person, per lifetime.
• After the Roth IRA owner becomes disabled, the distribution is made.
• After the Roth IRA holder’s death, the assets are dispersed to the Roth IRA holder’s beneficiary.

The 5-Year rule

Withdrawal of earnings may be subject to taxes and/or a 10% penalty, depending on your age and whether you’ve met the five-year rule. Here’s a quick rundown.

If you meet the five-year rule:

• Underage 59½: Taxes and penalties apply on earnings. If you use the money for a first-time home purchase ($10,000-lifetime maximum applies), if you have a permanent disability, or if you pass away and your beneficiary receives the distribution, you may be eligible to avoid taxes and penalties.
• Ages 59½ and older: No taxes or penalties.

If you don’t meet the five-year rule:

• Underage 59½: Taxes and penalties apply on earnings. If you use the money for a first-time home purchase (a $10,000-lifetime limit applies), qualified education expenses, unreimbursed medical expenses, if you have a permanent disability, or if you pass away and your beneficiary takes the distribution, you may be able to avoid the penalty (but not the taxes).
• Ages 59½ and older: Earnings are subject to taxes but not penalties.

Withdrawals: non-qualified distributions

A non-qualified distribution is a withdrawal of earnings that does not meet the foregoing criteria and may be liable to income tax and/or a 10% early distribution penalty. However, if the money is spent, there may be exceptions:

• For medical expenses that have not been reimbursed. If the distribution is utilized to cover unreimbursed medical expenses that total more than 10% of an individual’s adjusted gross income (AGI) in 2021 (or 7.5 percent for recent tax years prior to 2021).
• To cover the cost of medical insurance. If the person has lost his or her employment.
• Expenses for accredited higher education. If the distribution is used to pay for the Roth IRA owner’s and/or their dependents’ eligible higher education expenses. Tuition, fees, books, supplies, and equipment required for a student’s enrollment or attendance at an approved educational institution are all qualified costs that must be used in the year of withdrawal.
• For the costs of delivery or adoption. If made within one year of the event, you could get up to $5,000.

The contribution is reversed if you withdraw only the amount of your contributions made during the current tax year, including any gains on those contributions. For example, if you make a $5,000 contribution this year and the funds yield $500, you can take the $5,000 principal tax-free, and the $500 gain will be considered as taxable income.

Coronavirus-related distributions

The Coronavirus Aid, Relief, and Economic Security (CARES) Act included a specific provision that permitted taxpayers to obtain a coronavirus-related payout from all qualifying plans and IRAs up to $100,000 from January 1, 2020, through December 31, 2020. A qualifying individual, defined by the IRS as someone who has been negatively affected by coronavirus—either monetarily or through a family diagnosis—can receive the coronavirus-related distribution. Owners of retirement plans who were eligible for coronavirus-related benefits included:

• Diagnosed with SARS-CoV-2
• Whose spouse or dependent was diagnosed with SARS-CoV-2
• Who were financially impacted due to furlough, quarantine, layoff, or reduced work hours during the pandemic
• Who were unable to work due to lack of childcare during the pandemic
• Who were financially impacted due to the reduction of business hours or closure of their own business during the pandemic

The special provision allows the beneficiary of a retirement account to take the distribution as a conventional withdrawal with no repayment option or as a loan with a payback option. The early distribution penalty was waived, but the distribution was taxed as ordinary income. The withdrawal can be taxed as ordinary income in full in 2020 or over a three-year period in 2020, 2021, and 2022 under the CARES Act. You have till the end of the third year to repay the money if you plan to do so. Please keep in mind that you will be responsible for paying taxes on the distribution until the year you repay it.

Let’s say you took $15,000 out of your account in 2020. In 2020 and 2021, you’ll need to claim $5,000 on your tax returns. You won’t have to pay taxes on the remaining $5,000 if you refund the funds in full by 2022. You’ll also need to file an amended return for 2020 and 2021 in order to reclaim the taxes you already paid on the first two-thirds.

If you have various retirement accounts, a Roth IRA might be the best option for a coronavirus distribution. Remember that because Roth IRA contributions are made after-tax, withdrawals up to the amount of contributed funds are always tax-free.

Because Roth IRA withdrawals are made on the FIFO basis (first in, first out), and no earnings are deemed touched until all contributions are taken out first, your taxable payout from a Roth IRA would be considerably lower.

Roth IRA vs. traditional IRA

The filer’s tax bracket, the estimated tax rate at retirement, and personal preference all factor into whether a Roth IRA is better than a standard IRA. Individuals who plan to be in a higher tax band when they retire may find the Roth IRA more beneficial because the total tax avoided in retirement will be larger than the current income tax. As a result, Roth IRAs may assist younger and lower-income workers the most.

Indeed, investors who start saving with an IRA early in life benefit from compound interest’s snowball effect: your investment and earnings are reinvested, which generates additional Earnings, which are reinvested, and so on. Even if you intend to pay fewer taxes in retirement, your Roth IRA will provide you with a tax-free income stream. That isn’t the worst idea imaginable.

Those who do not require their Roth IRA assets in retirement can leave them to accumulate indefinitely and pass them on to their heirs tax-free. While the beneficiary of an inherited IRA must take distributions, they can extend the period of tax deferral by receiving distributions for a decade—and, in some situations, for their entire lives. Beneficiaries of traditional IRAs, on the other hand, beneficiaries of traditional IRAs must pay taxes on their distributions. A spouse can also roll over an inherited IRA into a new account and defer accepting income until they reach the age of 72.

Some people join or convert to Roth IRAs because they are concerned about future tax increases, and this account allows them to lock in current tax rates on the remaining conversions. Executives and other highly rewarded employees who are eligible to contribute to a Roth retirement plan through their employers—for example, a Roth 401(k)—can roll these plans into Roth IRAs without penalty and avoid having to take mandated minimum distributions when they reach the age of 72.

Is it better to invest in a Roth IRA or a 401(k)?

When deciding between a Roth IRA and a 401(k) retirement plan, there are numerous factors to consider. Each sort of account allows you to increase your money without paying taxes. When you make a deposit into a Roth IRA, you won’t get any tax benefits, but you’ll be able to withdraw your money tax-free when you retire.

In the case of 401(k)s, the opposite is true. Contributing a percentage of your paycheck to a 401(k) before income tax deductions is the basis for these accounts.

Roth IRA contribution limitations are often lower than 401(k) contribution limits. 401(k)s also allow businesses to match employee contributions. 401(k)s, on the other hand, frequently feature higher costs, mandatory payouts, and fewer investment alternatives.

How much can I put in my Roth IRA monthly?

The maximum yearly contribution amount for a Roth IRA in 2021 and 2022 is $6,000, or $500 per month for people under the age of 50. For people above the age of 50, this amount rises to $7,000 each year, or $583 per month.

What are the advantages of a Roth IRA?

While Roth IRAs do not offer employer matching contributions, they do offer a wider range of investing possibilities. Roth IRAs are also a good alternative for people who expect to be in a higher tax bracket as they get older.

You can withdraw your contributions (but not earnings) tax-free and penalty-free from a Roth IRA. Finally, you can control how your Roth IRA is invested by opening an account with a brokerage, bank, or other suitable financial institution.

What are the disadvantages of a Roth IRA?

One of the drawbacks of Roth IRAs is that, unlike 401(k)s, they do not provide an immediate tax benefit. Second, annual contribution limits in 401(k)s are about a third of those in IRAs. There are restricted or limited contribution amounts for some high-income persons. Furthermore, no payroll deduction is made automatically.

Conclusion

Roth IRAs have a significant advantage, including tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions (RMDs) beginning at the age of 72. However, there are certain disadvantages.

Individuals often profit from IRA retirement savings. Whether a traditional or Roth IRA is a superior investment relies on a number of factors, including your salary, age, and when you expect to be in a lower tax bracket—now or later in life. Please seek the advice of a tax specialist, financial planner, or financial advisor to assist you in making a more informed decision so that your retirement plan is tailored to your unique financial circumstances.