What Is a Roth IRA? The Complete Guide

You may have heard of an IRA: it’s a tax-advantaged investment account for your retirement fund. But did you know there are two types of IRA accounts? Traditional IRAs and Roth IRAs can both reduce your tax bill as you plan for retirement, but the Roth IRA has some unique features and advantages.

What is a Roth IRA?

A Roth IRA is a tax-advantaged individual retirement account. In exchange for keeping your money in the account until retirement age and following other rules, you get a tax break on the money your investments may earn. 

You can invest your Roth IRA funds in almost any security, like stocks, bonds, mutual funds, and exchange-traded funds (ETFs). The only exceptions are life insurance and collectibles. 

It’s important to know that a Roth IRA is not a savings account. It’s a portfolio of investments, so keep in mind that all investment involves risk, including the risk that you could lose money. 

How do Roth IRAs work?

When you open a Roth IRA, you fund it with after-tax dollars, i.e, the money you’ve earned and already paid income tax on. Then, you can make additional contributions to the account over time, including regular contributions, rollover contributions, and more. Ideally, the value of your investments will also increase, and your account balance will grow throughout the years. 

Once you reach retirement age, which is 59½ in most cases, you can take qualified distributions, or withdrawals, from your account. Here’s where the tax advantage comes in: As long as your withdrawals meet the requirements for qualified distributions, you won’t owe any taxes on them. That means you don’t pay any taxes on money your investments earn.

Another benefit is the possibility of paying less tax overall on some of your contributions. Many people’s salaries increase over time; you may be in a lower tax bracket early in your career, and in a higher tax bracket as you near retirement. Because you pay income tax before you contribute to your Roth IRA, you could wind up paying less tax on the money you invest when you are in a lower tax bracket. 

You are allowed to take money out of your Roth IRA before age 59½. However, withdrawals made before that age usually aren’t considered qualified distributions, so you’ll have to pay tax on any investment income you withdraw, plus an additional 10% early withdrawal tax. 

Roth IRAs vs. Traditional IRAs

Both types of IRAs are tax-advantaged retirement accounts with many similarities, though they vary in several details. The most notable differences are when you get a tax advantage and what money is taxed.

Here’s another way to look at it: 

• With a Roth IRA, you pay income taxes now instead of in retirement. Later, your qualified withdrawals are tax free, including money you’ve earned on investments. 
• With a traditional IRA, you don’t pay income tax when you make contributions. Later, you pay income tax on all the funds you withdraw: the money you’ve contributed and the investment income. 

How to contribute to a Roth IRA 

There are a few ways to fund your Roth IRA, both when you open it and when you make contributions thereafter. Most contributions to IRAs are usually regular contributions: money from your paycheck, a lump sum from your tax refund, and so on. Transfer and rollover contributions, on the other hand, move money from one retirement plan to another. 

Regular contributions

Regular contributions must be made in cash; you can’t contribute things like property, securities, rental income, or interest income. 

Generally, you can only contribute earned income: the salary, wages, commissions, and bonuses you’re paid by your employer. If you’re self-employed, your earned income is your net earnings from your business, minus any deductions for contributions made on your behalf to other retirement plans and the deductible part of your self-employment taxes. 

Transfers

A transfer, also called a direct transfer or a trustee-to-trustee transfer, means one Roth IRA custodian sends money directly to another Roth IRA custodian, and the money does not pass through an individual’s hands. With a direct transfer, no taxes are withheld.

Rollover contributions 

Rollovers involve contributing money from one Roth IRA account to another. The basic rule is that if you receive a distribution from your Roth IRA, and then deposit it in another Roth IRA within 60 days, it’s a rollover, and the money is not taxed. 

It can get more complicated in practice, though. If you miss the 60-day window, you’ll likely have to pay penalties and taxes. Also, the financial institution may be required to withhold 10%-20% for federal income tax. If you complete the rollover correctly, you’ll get that back later when you file your taxes. But in the meantime, you’ll need to replace that 20% to finish the rollover; otherwise, you may owe taxes and penalties on it.

You can generally only do one rollover per year, no matter how many Roth IRAs you own. And not all retirement plans allow rollover contributions.

If you want to transfer or rollover money from a different kind of retirement account, like a traditional IRA or 401(k), into your Roth IRA, it’s likely permissible, but the rules vary based on the type of plan. This IRS rollover chart explains what types of accounts can be rolled over and the restrictions that apply.  

What is the max contribution to a Roth IRA?

You can contribute money to your Roth IRA as often as you want, as long as you don’t exceed the annual limit. As a general rule, the contribution limit for both traditional and Roth IRAs in 2023 is $6,500. If you are at least 50, you can put in an additional $1,000. There’s one exception: if you earn less than the contribution limit, you can only contribute up to the amount of your taxable compensation for the year. For example, if you earn $4,500 in 2023, that’s the most you can contribute to an IRA. 

While you can have more than one IRA account, the annual contribution limit applies to the total contributions made to all traditional and Roth IRA accounts you have. That means someone under 50 could contribute, say, $3,250 to a traditional IRA and $3,250 to a Roth IRA, for a total of $6,500 for the year. 

Exceptions to Roth IRA contribution limits

There are a few special circumstances that affect how much you may be able to contribute to your Roth IRA.

Employer contributions

Some small businesses and self-employed individuals can open a SEP-IRA or SIMPLE IRA. These plans allow them to contribute to their employees’ retirement; keep in mind that there are generally limits on employer contributions. If your employer contributes to one of these accounts for you, that doesn’t count toward the maximum contribution you can make to any personal IRA accounts you have. For instance, you can contribute $6,500 to your Roth IRA if you’re under 50, even if your employer contributes money to your SEP-IRA. 

Reduced contribution limits

In 2023, you might have a lower maximum contribution if you earn:

• $218,000 or more but less than $228,000, if you are married filing jointly or a qualifying widow(er)
• $138,000 or more but less than 153,000, if you are single, a head of household, or married filing separately and you didn’t live with your spouse at any time during the year
• More than $0 but less than $10,000, if you are married filing separately and you lived with your spouse at any time during the year.

For more details about how this might affect you, you may want to check out the IRS table on reduced contribution limits for Roth IRAs based on modified gross income.  

Spousal IRA contributions

In general, you can’t contribute to a Roth IRA if you have no taxable compensation. However, if you’re married and file your taxes jointly, the non-working spouse can open a Spousal IRA, and the working spouse can contribute to that account, up to the annual limit. That’s in addition to the annual limit for their own Roth IRA. 

Here’s a hypothetical example of how it works: Taz and Ali are 40 years old, married, and file joint taxes. Taz earns a salary of $75,00 a year; Ali does not earn taxable income from a job. Taz can contribute $6,500 to their Roth IRA. Ali can open a Spousal IRA, and Taz can contribute $6,500 to it. So, Taz can contribute a total of $13,000 to these two IRAs in 2023.

The total contribution, however, including the spousal IRA contributions, can’t exceed the amount of taxable compensation reported on your joint return, and there are a few other restrictions on Spousal IRA contributions. 

Note: Even though the contributions come from the working spouse, the non-working spouse is the sole owner of their own IRA.

Roth IRA withdrawals

While you can withdraw money anytime, the rules for taking money out of your Roth IRA are intended to encourage people to put aside money for retirement. You reap the tax advantages only if you take qualified distributions; otherwise, you’ll probably owe taxes and penalties on the money you take out.

Note that, unlike traditional IRAs, you’re not required to withdraw money from your Roth IRA at any point. You can leave your money in the account until you die and, generally, it will pass to your heirs tax-free. 

What is a qualified distribution from a Roth IRA?

A qualified distribution is a withdrawal at least five years after you started making contributions; this is called the five-year holding period. In addition, one of the following must be true:

• You are at least 59½ years old
• You are disabled as defined by the IRS
• It’s a distribution to a beneficiary or your estate following your death
  

Early withdrawal penalties on Roth IRA earnings

The funds in your Roth IRA fall into two categories:

• Regular contributions: money you’ve invested with after-tax dollars
• Earnings on contributions: money your investments have earned while in the Roth IRA

Because you’ve already paid income tax on your regular contributions, you can withdraw them at any time without paying taxes or penalties. However, if you withdraw the earnings without meeting the requirements for a qualified distribution, you’ll typically have to pay income tax, plus an extra 10% early withdrawal penalty. There are a variety of exceptions, such as distributions used to pay for certain medical expenses, purchasing a first home, or higher education.

Pros and cons of Roth IRAs

Roth IRAs offer significant tax advantages for many people, but the advantages come with strict rules about contributions and withdrawals. Here are some top pros and cons.

Roth IRA Pros

• Investment earnings in the account grow tax-free 
• Qualified distributions are tax-free
• Can leave money in the account for your entire life

Roth IRA Cons

• Unlike a traditional IRA, contributions are not tax-deductible
• Some withdrawals can result in taxes and penalties
• The amount you can contribute is limited

Who is eligible to open a Roth IRA?

You can generally contribute to a Roth IRA if you receive taxable compensation and your 2023 modified adjusted gross income is less than:

• $228,000 if you’re married filing jointly or a qualifying widow(er)
• $153,000 if you’re single, a head of household, or married filing separately, provided you didn’t live with your spouse at any time during the year
• $10,000 if you’re married filing separately and lived with your spouse at any time during the year

Is investing in a Roth IRA right for you?

Roth IRA vs. traditional IRA… Roth IRA vs. 401(k)… sorting out retirement account options can be tricky. The great news is that there are tax advantages with all of these options, and you don’t necessarily have to pick just one.
For many people, the primary appeal of Roth IRAs is eliminating taxes on the money your investments earn. If that sounds good to you, a Roth IRA might be a strong player in your retirement strategy. Learn how to open a Roth IRA and start building toward your golden years.

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