Jul 21, 2023
What Is a Roth IRA? The Complete Guide
|What is a Roth IRA?|
A Roth IRA is a tax-advantaged individual retirement account where you invest after-tax dollars that will then grow tax-free. It shares some characteristics with a traditional IRA, such as the same annual investment limits, but a Roth IRA features some unique features and advantages.
There are many types of investment accounts you can use to grow your money for retirement or other goals. One of the main reasons investors choose a Roth IRA is the potential for tax advantages later in life: if you expect to be in a higher tax bracket after you retire, you can benefit from your contributions being taxed at a lower rate when you invest now compared to the higher tax rate you expect in the future.
In this article, we’ll cover:
- How a Roth IRA works
- Roth IRA contributions
- Roth IRA distributions
- Investment choices in a Roth IRA
- Roth IRAs vs other retirement accounts
How do Roth IRAs work?
Investors contribute to their Roth IRA with after-tax dollars, which means they’ve already paid taxes on them. That money then grows tax-free; once you reach age 59½, qualified distributions of your contributions and earnings are tax-free.
A Roth IRA can be opened at many banks, brokerage companies, federally insured credit unions, and savings and loan institutions. While investors can open a Roth IRA at any time, contributions for a tax year are required to take place by the investor’s tax-filing deadline, which is normally April 15 of the following year.
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Roth IRA contributions
There are several ways investors can go about getting started with a Roth IRA and a number of eligibility requirements they have to consider.
Who is eligible to open a Roth IRA?
Anyone who earns income can contribute to a Roth IRA, regardless of age. However, the IRS sets income eligibility limits for Roth IRAs. At higher income levels, investors may be able to contribute to a traditional IRA but not a Roth IRA.
If you’re a high-income investor who wouldn’t normally qualify for a Roth IRA, take a look at the backdoor Roth IRA. This loophole allows high earners to legally take advantage of Roth tax benefits.
What is the max contribution to a Roth IRA?
For 2023, investors under 50 can contribute a maximum of $6,500 to their Roth IRA, and those 50 and older can make up to $7,500 in contributions. However, that limit may be reduced based on your income and tax filing status.
If you make over $138,000 if single or less than $218,000 if married and filing jointly, your maximum contribution limit will be lower. These income limits are updated periodically by the IRS.
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, earning $4,500 in 2023 means you can only contribute up to $4,500 for that year.
|Filing status||2023 income range||2023 maximum annual contribution|
|Single or married, filing separately (if you didn’t live with your spouse during the year)||Less than $138,000||$6,500|
$7,500 if age 50+
|Between $138,000 and $153,000||Limited contribution allowed|
|$153,000 or more||No allowed contributions|
|Married filing jointly or qualified widow(er)||Less than $218,000||$6,500|
$7,500 if age 50+
|Between $218,000 and $228,000||Limited contribution allowed|
|$228,000 or more||No allowed contributions|
|Married filing separately (if your spouse lived with you during the year)||Less than $10,000||Limited contribution allowed|
|$10,000 or more||No allowed contributions|
Notably, these investment limits apply to all IRA accounts you have combined, both Roth and traditional IRAs. For example, if you’re under 50, you could contribute $3,250 to your traditional IRA and $3,250 to your Roth IRA, for a total of $6,500 in the year.
Exceptions to Roth IRA contribution limits
There are a few special circumstances that will affect your Roth IRA contributions.
- 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.
- Spousal IRA contributions: Generally, taxable compensation is required in order to contribute to a Roth IRA. However, if you’re married and file your taxes jointly, a spouse who doesn’t earn any income 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. There are, however, some restrictions on spousal IRA contributions.
- Reduced contribution limits: For a full breakdown of how much you can contribute at different income levels and filing statuses, check out the IRS table on reduced contribution limits for Roth IRAs.
How to contribute to a Roth IRA
- Regular contributions: Regular contributions must be made in cash and can’t include things like property, securities, rental income, or interest income. Generally, you can only contribute earned income such as salary, wages, commissions, and bonuses. If you’re self-employed, your earned income is your net earnings from your business minus deductions to other retirement plans and 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: Investors who have a Roth 401k, in which they’ve already paid taxes on their contributions, are able to roll that money into a Roth IRA. Rollover contributions do not count towards their yearly contribution limit. This IRS rollover chart explains what types of accounts can be rolled over and the relevant restrictions.
Roth IRA distributions
A Roth IRA is a retirement account and, like all retirement accounts, comes with rules and penalties around how and when you can withdraw your investments.
When can you withdraw from a Roth IRA?
There are two types of penalty-free distributions, or withdrawals, from your Roth IRA.
- Initial investment: The money you put into your Roth IRA is relatively liquid. You can withdraw up to the sum you put into the account without paying taxes or penalties. Your contributions are not considered taxable income because you already paid taxes on that money before putting it in the account.
- Qualified distributions: A qualified distribution is a withdrawal that takes place at least five years after you started making contributions and is taken when you are either at least 59½ years old, you are disabled as defined by the IRS, or the a distribution is to a beneficiary of your estate following your death.
The five-year rule
The Roth IRA five-year rule says that you cannot withdraw earnings tax-free until it’s been at least five years since you first contributed to a Roth IRA account. This five-year waiting period applies even to those aged, 59 ½ and older, who would otherwise get qualified distributions.
Early distribution penalties
People investing for retirement lose out on the tax advantages of a Roth IRA if they take out their money early. If you withdraw earnings that don’t meet the rules for a qualified distribution, you’ll have to pay income tax on that money, plus a 10% penalty tax. There are a few exceptions, such as money withdrawn for a first-time home purchase and qualified educational expenses. You can find details on all the exceptions to the early distribution penalty at the IRS website.
Investment choices in a Roth IRA
Roth and traditional IRAs are both relatively straightforward accounts once you’ve met their requirements and understand their limitations. You can choose the investments in your Roth IRA yourself or use robo-advisor to put your money to work in several different kinds of investments.
- Individual stocks
- Individual bonds
- Exchange-traded funds (ETFs)
- Index funds
- Mutual funds
Keep in mind that Roth IRA accounts are investment vehicles, not investments in and of themselves. You can make money with a Roth IRA by investing your contributions in securities. That means you must put your contributions into an investment once you’ve opened your account, or your money won’t be doing any work for you. When you open a Roth IRA, be sure you understand how the financial institution handles your contributions when you make them to ensure your money is being invested, not just sitting around as cash.
Pros and cons of a Roth IRA
Roth IRAs can be a powerful vehicle in your retirement investing strategy, but they also come with a number of drawbacks investors should consider.
Benefits of a Roth IRA
- Tax-free growth: Investors enjoy tax-free growth on their investments. As long as you withdraw your earnings after you’re 59½ and have met the five-year rule, you don’t pay any tax on your earnings.
- Tax-free distributions: Investors don’t have to pay taxes on their withdrawals because they paid their taxes up front, possibly when they were in a lower tax bracket.
- Can withdraw contributions before retirement: The money you contribute to the account is liquid, which means you can withdraw your contributions anytime without any penalties should you need that money.
- Flexible timing: While investors have an annual contribution limit, they can contribute up to that limit anytime during that tax year. So you could contribute a little bit from each paycheck throughout the year so that you’re adding money to your retirement account on an ongoing basis.
- No distribution minimums: Upon retirement, investors don’t have required distributions, so they can theoretically hold money in their account as long as they want. This is a major difference between Roth IRAs and traditional IRAs; some investors opt for a Roth IRA because they want to keep their money invested for as long as possible or pass their IRA down to their heirs after death.
Drawbacks of a Roth IRA
- No tax-deductible contributions: Unlike with a traditional IRA, you cannot deduct your contributions from your taxable income because you’ve already paid taxes before depositing your money into a Roth IRA.
- Income limit: If you earn more than the income limits, the amount of money you can contribute will be reduced. Some people earn too much to contribute to a Roth IRA directly and must use a backdoor Roth IRA or traditional IRA instead.
- Withdrawal taxes and penalties: Any withdrawals that aren’t qualified distributions are subject to taxes and penalties, barring certain narrow exceptions. These penalties may outweigh any tax advantages you gain with a Roth IRA.
- Low maximum contribution: The maximum contributions you can make to a Roth IRA are relatively low. Many investors will likely need other retirement vehicles in order to save enough for retirement.
- No employer matching: Unlike a 401(k) or other employer-sponsored retirement account, a Roth IRA does not provide opportunities for employer contributions.
Roth IRA vs. traditional IRA vs. 401(k)
A Roth IRA, traditional IRA, and 401(k)s are all types of retirement accounts. Each account has different rules, limitations, and benefits that investors can take advantage of, and many people will hold all of these account types.
|Roth IRA||Traditional IRA||401(k)|
|Eligibility||Anyone with earned income below the income restrictions||Anyone with earned income||Dependent on your employer|
|Contribution limit||$6,500 ($7,500 for those age 50+) annually between Roth and traditional IRAs||$6,500 ($7,500 for those age 50+) annually between Roth and traditional IRAs||$22,500|
|Taxes||Contributions are made with after-tax money; investors don’t pay taxes on qualified distributions||Contributions are made pre-tax and may be deducted from taxable income; taxes on contributions and earning are paid upon distribution||401(k)s are funded with pre-tax money; Roth 401(k)s are funded with after-tax money|
|Distributions||Contributions are made pre-tax and may be deducted from taxable income; taxes on contributions and earnings are paid upon distribution||Available after five years and age 59½; minimum distributions required at age 72||Available after; age 59½; minimum distributions required at age 72|
|Investment options||More options than a 401(k); self-directed||More options than a 401(k); self-directed||Limited by employer|
Remember, investors are allowed to have all these investment vehicles at the same time. Many people invest in a 401(k) up to the amount their employer matches in order to take make full use of that benefit, then “max out” their contributions to a Roth IRA or traditional IRA. By diversifying where you make your retirement investments, you can take advantage of the different benefits offered by the different account types.
Is investing in a Roth IRA right for you?
Once you understand what a Roth IRA is and what it can do for you, you may want to jump right in. But it’s important to take a look at this tax-advantaged retirement account from the perspective of your whole portfolio.
A Roth IRA can make a lot of sense at certain points in your life, but whether or not it’s right for you comes down to how much money you’re making now and how much you expect to make when you stop working. Young investors who expect to make more money in the future could benefit from front-loading their tax burden; you can pay taxes on your money now while you’re in a lower tax bracket, then let it grow tax-free in a Roth IRA.
Other investors may benefit more from a traditional IRA or 401(k) because those contributions are tax-deductible, which could lower your tax burden for the years in which you contribute.
Which tax-advantaged retirement account, or combination of accounts, is right for you will depend on your unique situation and plans for the future. In any case, it’s never too early to start saving for retirement. The sooner you start, the more wealth you can accumulate for your golden years.
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