savings accounts, it's important to recognize these are two completely different types of accounts created to serve different purposes. Roth IRAs are exclusively for helping people save for retirement. Savings accounts are designed to give people quick, easy access to their money.
Savings accounts can be a safe place to keep cash for emergencies and short-term goals. Roth IRAs are for long-term goals, primarily retirement. However, Roth IRAs can also be used for withdrawals in an emergency because your Roth contributions are always accessible without penalty. However, your earnings are not.
If you've met the five-year holding requirement, you can withdraw money from a Roth IRA with no taxes or penalties. Remember that unlike a Traditional IRA, with a Roth IRA there are no required minimum distributions.
A Roth IRA is an individual retirement account (IRA) that allows you to withdraw money (without paying a penalty) on a tax-free basis after age 59½, and after you have owned the account for its five-year holding period.
But keeping your emergency fund in a traditional savings account may not be the best solution. To make your money work harder for you, a Roth IRA could be a better option. Despite the fact that a Roth IRA is a retirement savings account, it can also double as an emergency fund.
Let's say you open a Roth IRA and contribute the maximum amount each year. If the base contribution limit remains at $7,000 per year, you'd amass over $100,000 (assuming a 8.77% annual growth rate) after 10 years. After 30 years, you would accumulate over $900,000.
If you contribute 5,000 dollars per year to a Roth IRA and earn an average annual return of 10 percent, your account balance will be worth a figure in the region of 250,000 dollars after 20 years.
If your age is greater than 50, it likely doesn't make sense to convert because there is not enough time to allow the Roth IRA growth to exceed the tax cost today.
The Bottom Line. In many cases, a Roth IRA can be a better choice than a 401(k) retirement plan, as it offers more investment options and greater tax benefits. It may be especially useful if you think you'll be in a higher tax bracket later on.
The 5-year aging rule applies to inherited Roth IRAs as well, and rules around them can be complicated. To make qualified withdrawals, it must be 5 years since the beginning of the tax year when the original account owner made the initial contribution, even if the new owner is 59½ or older.
A Roth IRA differs from a traditional IRA in several ways. Contributions to a Roth IRA aren't deductible (and you don't report the contributions on your tax return), but qualified distributions or distributions that are a return of contributions aren't subject to tax.
The Roth IRA five-year rule
This rule for Roth IRA distributions stipulates that five years must pass after the tax year of your first Roth IRA contribution before you can withdraw the earnings in the account tax-free.
Roth IRAs allow for 100% tax-free qualified distributions, with no required minimum distributions. Savings accounts don't offer any tax benefits; interest earned is considered taxable income. Roth IRAs have an annual contribution limit. For 2022, the limit is $6,000 or $7,000 if you're 50 or older.)
Roth IRAs aren't investments and don't pay interest or earn interest, but the investments held within Roth IRAs may earn a return over time. Depending on your investment choices, you may be able to earn an average annual return between 7% and 10%. Of course, you may earn less.
For the most affluent investors, the decision may be moot anyway due to Internal Revenue Service (IRS) income restrictions for Roth accounts. For 2023, individuals can't contribute to a Roth if they earn $153,000 or more per year—or $228,000 or more if they are married and file a joint return.
You can shift money from a traditional IRA or 401(k) into a Roth IRA by doing a Roth IRA conversion. The amount you convert is added to your gross income for the tax year in which you make the switch. Tax rates range from 10% to 37%, and the conversion could push you into a higher tax bracket.
"Unfortunately, the income limits on Roth IRAs make it difficult for many higher-income individuals to contribute directly to these accounts," said Hayden Adams, CPA, CFP®, director of tax and wealth management at the Schwab Center for Financial Research.
Given that the money in retirement accounts, including IRAs, is typically invested, the overall value of the account is subject to the whims of the market. That means that if the market experiences a downturn or correction, your Roth IRA balance is likely to decline as well.
The minimum amount to open a Roth IRA varies depending on the financial institution. But many, particularly online brokers, don't require a minimum amount of money to open an account.
With a Roth IRA you contribute after-tax money to the account, so you don't get to avoid tax on your contributions, as you might with a traditional IRA. In exchange, your money grows tax-free and you'll be able to withdraw it tax-free at retirement, defined as age 59 ½ or older.
Assuming a 10% return on your investments, it would take around 29 years with the same $6,500 per year contribution. Becoming a Roth IRA millionaire will take time. It is much more likely that people will become retirement account millionaires, which means taking into account their 401(k) and traditional IRA balances.
If you're 25, you should aim to max out your IRA every year. For 2024, a 25-year-old can contribute up to $7,000 to an IRA. It might seem unnecessary to save for retirement at such a young age, but giving your money time to grow is one of the best things you can do for your future self.
Maximizing your contributions to a Roth IRA can greatly benefit your retirement planning and provide peace of mind for the future. With the potential for tax-free withdrawals, the ability to pass on the account to heirs, and the flexibility to use it as a last-resort emergency fund, it is a smart financial decision.