A Roth IRA is an Individual Retirement Account, or IRA, to which you contribute outside of your work plan and from which you can make tax-free withdrawals if you meet certain conditions.
This potential for tax-free growth makes Roth IRAs a powerful retirement savings vehicle. Roth IRAs are also one of the few retirement savings vehicles that you can withdraw without penalty before retirement age under certain conditions – although this is generally discouraged.
Roth IRAs work by allowing you to set aside after-tax dollars in a tax-sheltered account where they can grow tax-free. Unlike traditional IRAs, your Roth IRA contributions are not tax deductible. But even if you don’t get a tax deduction for your contributions today, you can withdraw the money tax-free later if you follow the rules. This means that the income you make on your contributions is never taxed by the IRS.
To see how powerful this tax-free growth can be, consider a simplified example:
Let’s say you put $6,000 into your Roth IRA today. If you achieve an average annual return of 7% over the next 20 years, your account will be worth more than $23,000. Since the money is in a Roth, you will never have to pay taxes on that growth over $17,000.
If you had placed your $6,000 in a traditional IRA instead, you would be tax at your ordinary income rate when you withdraw the funds. In return, however, you were able to take advantage of a $6,000 tax deduction the year you contributed to the traditional IRA.
As with traditional IRAs, the IRS limits the amount you can contribute each year. In 2022, this limit is $6,000. If you are 50 or older, you can contribute an additional $1,000 catch-up contribution for a total annual contribution of $7,000. But there’s another important caveat: Only people who earn below certain income limits can contribute to Roth IRAs. These IRS income limits are imposed on a sliding scale based on your modified adjusted gross income.
Individuals must earn less than $129,000 per year ($204,000 for married couples filing jointly) to contribute the full amount to a Roth IRA in 2022. If you earn $144,000 or more per year as an individual filer ($214,000 or more per year for married couples filing jointly), you cannot contribute to a Roth IRA in 2022. If you fall between these ranges, you can contribute a reduced amount. Contribution and income limits on Roth IRAs can change each year, so keep an eye on the IRS website for revised amounts.
It’s also worth noting that your contributions to a Roth IRA must not exceed your earned income. If you earn less than $6,000, your contribution is capped at your earned income for the year. For example, if you only earn $4,000 in earned income — which doesn’t include alimony, child support, Social Security, or unemployment benefits — you can only contribute $4,000 to a Roth IRA that year.
You can also only contribute cash to a Roth IRA. You cannot fund your Roth IRA with other investments such as stocks or bonds. However, once the money is in your Roth IRA, you can invest it in almost anything you want, as long as your targeted investment is offered by the company that administers your Roth IRA.
In order for you to withdraw your money from a Roth IRA tax-free, you must meet certain IRS requirements. First, it must have been at least five years since you made your first contribution. Note that this does not mean that all the money you withdraw has to be in the account for five years. As long as there was $1 in the account five years ago, you can withdraw all the money you’ve invested so far tax-free, provided at least one of the following conditions be true:
- You are 59.5 years old.
- You are disabled.
- You use the money to buy a first home.
If you do not meet the above conditions, any withdrawal of income from your Roth IRA could be subject to a 10% penalty. You can withdraw any amount of the contributions you have made at any time without penalty – even before age 59.5 – provided the Roth account complies with the five year age rule.
Another unique benefit of a Roth IRA is that these accounts are not subject to required minimum distributions, or RMDs, which start at age 72 for traditional retirement accounts. Because the IRS has already taxed the money you put in your Roth IRA, it doesn’t impose an RMD, which means you can leave the money there for as long as you want. This can make Roth IRAs a great estate planning tool as a way to leave a tax-free inheritance.
Roth IRAs are powerful retirement savings vehicles. Not only do they allow your savings to grow tax-free up to retirement, but they also provide a tax-free source of income in retirement. This last benefit can be useful to help you manage your taxable income after you retire. Most advisors recommend having multiple streams of retirement income, including taxable and non-taxable, for this reason.
Roth IRAs can also be effective wealth transfer tools by helping to minimize estate taxes. In most of the cases, heritage of a Roth IRA is tax-free. And because Roth IRAs aren’t subject to RMDs, you can leave the money in your heirs’ account if you don’t need it. However, your heirs may have a shorter time to withdraw the funds.
Even if you earn above the IRS income limits for a Roth IRA, you can still take advantage of this retirement savings vehicle through a strategy called the Roth IRA backdoor. This legal strategy allows high-income taxpayers to put money into a Roth IRA by converting traditional IRA contributions into a Roth IRA. You start by contributing to a traditional IRA, which has no income limit, then convert the money to a Roth IRA. You’ll pay taxes on the money when you convert it, but the funds can then stay in your Roth IRA for as long as you want without being taxed again.
Although backdoor Roth IRAs are legal under current law, if the Build Back Better Act is enacted, this tool could be banned as early as 2022.
- Tax-free growth. Investment income in a Roth IRA is never taxed, provided you withdraw it according to IRS rules.
- Withdrawals are tax free. You don’t have to pay taxes on qualified withdrawals from a Roth IRA, making it easier to manage your taxable income in retirement.
- No RMD. Roth IRAs are not subject to required minimum distributions, so you can leave the money in the account for as long as you want.
- Extended contribution window. You have until the tax filing deadline to contribute to a Roth IRA for the previous year. For example, you have until Tax Day, which falls on April 18, 2022, to make a 2021 Roth IRA contribution.
- Easy withdrawals. You can access your Roth IRA money at any time after the five-year rule is met, although you may incur a penalty if you withdraw your earnings before age 59.5.
- Wide investment options. You can invest in almost any security in a Roth IRA.
- No tax deduction for contributions. You cannot take a tax deduction today for your Roth IRA contributions.
- Income Limits. People who earn above certain IRS income limits cannot contribute to Roth IRAs.
- Low contribution limits. Contribution limits on Roth IRAs — $6,000 in 2022 — are significantly lower than those on 401(k)s and other employer-sponsored plans.
It depends on your investment and retirement needs. With traditional IRAs, you can now get a tax deduction for your contributions, but you’ll have to pay taxes on your earnings when you withdraw. With Roth IRAs, you contribute with money that has been subject to income tax, but any investment gains accrue tax-free. Most advisors recommend keeping a variety of account types, including traditional and Roth IRAs.
A 401(k) is an employer-sponsored plan that lets you put pre-tax wages into a retirement fund. A Roth IRA has no connection to your employer and uses taxed cash for contributions.