Oct 17, 2022
How Does a Roth IRA Work?
A Roth IRA is a type of Individual Retirement Account(IRA) funded with after-tax income. While the money you put into your Roth IRA isn’t tax deductible at the time you contribute it, withdrawals made after age 59½ are tax-free. That means you don’t pay any tax on the earnings in your account, as long as you follow the rules for taking qualified distributions. This is one of the primary differences between a Roth IRA and a traditional IRA.
Investors who choose Roth IRAs enjoy benefits like no required minimum distributions, no-penalty contribution withdrawals, and tax-free growth. Additionally, you can open a Roth IRA account even if you already have a 401(k), which can help you put more money toward retirement. Especially if you predict that your marginal taxes will be higher in retirement than they are right now, a Roth IRA could be a retirement savings option worth looking into.
In this article, we’ll cover:
- How money grows in a Roth IRA
- Who can open a Roth IRA
- Contribution limits
- Withdrawal rules and penalties
- How to get the most out of a Roth IRA
How your money grows in a Roth IRA
So how does a Roth IRA work? Your Roth IRA is designed for long-term retirement savings. Because you’re contributing after-tax dollars and you’re not required to make withdrawals, your money can stay in the account to grow tax-free as long as you like. Your Roth IRA uses two sources of income to grow: the contributions you make and the earnings it accumulates through returns on investments. Historically, Roth IRAs have had an annual average return of 7–10%.
Keep in mind that your Roth IRA is an investment account, not a savings account, and all investing involves risk.
The funds you contribute to your Roth IRA can be invested in a wide variety of assets, including:
- Mutual funds
- Exchange-traded funds (ETFs)
- Money market funds
- Certificates of Deposit (CDs)
- Real estate (with restrictions)
There are some types of investments that aren’t allowed, such as life insurance, collectibles, and derivative trades with unlimited risk. And while you can hold real estate in your Roth IRA, you can’t benefit directly from the property by living in it or receiving rental income.
Who can open a Roth IRA?
Anyone who has earned income, no matter their age, can contribute to a Roth IRA. However, there are income restrictions and contribution limits to consider. Regardless of your age, you must earn below a certain dollar amount annually, either as an individual or as part of a married couple, to contribute to a Roth IRA.
The IRS stipulates income limitations for contributing to a Roth IRA. As of 2022, single filers with an annual adjusted gross income (AGI) under $120,000 can contribute the full amount allowed by the IRS. Single filers earning between $129,000 and $144,000 can contribute, but the contribution limit is lower. And those earning $144,000 or more are not eligible to contribute to a Roth IRA. If you’re married and filing jointly or a qualifying widower, your combined AGI must fall below $214,000 to contribute; if your AG is over $204,000, the amount you can contribute is lower.
There is a loophole that allows high earners to get around the income limit and reap the tax benefits of a Roth IRA by making indirect contributions. This strategy, known as a “backdoor IRA,” involves making a contribution to a traditional IRA and then converting that account to a Roth IRA. The income threshold does not apply to account conversions, and you can repeat the process each year.
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Roth IRA contribution limits
Annual contribution limits apply to every Roth IRA account holder regardless of age or income. Contributions as of 2022 are limited to $6,000 per year until age 50, at which point you can start contributing up to $7,000 annually. If you earn less than the contribution limit, you can only invest up to the amount of your total taxable income for the year. And if your AGI falls into the range that reduces your contribution limit, the IRS provides a worksheet for determining your Roth IRA contribution limit based on income.
Withdrawal rules and penalties
With a Roth IRA, the IRS makes a distinction between the post-tax money you’ve contributed and the money your contributions have earned while invested in the account. You can withdraw your contributions at any time with no penalties. However, the downside of a Roth IRA is that there are strict regulations regarding when you can withdraw your earnings.
A Roth IRA is a retirement account, and IRS regulations are designed to encourage you to keep your money invested until you reach retirement age. In most cases, withdrawing your earnings before age 59½ will incur a 10% penalty; you’ll also have to pay income tax based on your tax bracket. In addition, you must have had your Roth IRA for five years before you can withdraw earnings without penalty, regardless of your age. That said, there are some exceptions to the early-withdrawal penalties for IRAs, including purchasing your first home or paying for some education expenses.
While there are rules governing qualified distributions, you’re not actually required to withdraw funds from your Roth IRA. Unlike a traditional IRA, which mandates that you must begin taking distributions at age 72, a Roth IRA allows you to keep your money in your account indefinitely.
What are qualified distributions?
Qualified distributions are the tax-free, penalty-free withdrawals of earnings from your Roth IRA. In practice, this generally means the withdrawals you make after you’re 59½. That said, there are a few situations in which a withdrawal is considered a qualified distribution even if it’s taken early: it qualifies for an exception, you become permanently disabled, or the distribution is made to a beneficiary or your estate after your death.
How to get the most out of a Roth IRA
The earlier you start building your retirement savings, the more time your money has to grow. So you might want to open a Roth IRA as early as you can, even if you can’t contribute up to the annual limit right away. Be sure to pay close attention to the Roth IRA rules in order to avoid penalties that could eat away at your income: avoid contributing more than is allowed, and don’t take early distributions that don’t qualify for an exception.
Another way to maximize your retirement savings is to contribute the maximum allowed to your Roth IRA each year. Keep in mind that the contribution limit doesn’t stay the same from year to year. The IRS might increase it based on inflation, allowing you to put aside more money for retirement.
Invest in your retirement today
A Roth IRA can be a valuable way to grow your nest egg for the future. And it doesn’t have to be your only source of retirement savings. You’re allowed to have a traditional IRA, a 401(k), and other investments in conjunction with your Roth account.
It’s never too early to start saving for the future. With a variety of retirement accounts and investment options, Stash makes planning for the future easier, regardless of your current income level.
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