A Roth IRA is an individual retirement account that lets you save after-tax money for use in retirement. Because you already paid taxes on the money you put into a Roth IRA, your money grows tax-free. You can also withdraw money without taxes or penalties when you meet specific account requirements.
Although there are several types of individual retirement accounts (IRAs), a Roth IRA can help you supplement your current savings. And it’ll hedge against the chance that you’ll be in a higher tax bracket when you retire than you are now.
Roth IRAs are popular retirement tools. So it’s essential to understand a Roth IRA’s benefits, drawbacks and how it works before opening one.
How does a Roth IRA work?
Many people are familiar with a 401(k) retirement account their employer offers. Money from your paycheck is put into your 401(k) before taxes are calculated, which lowers your tax burden in the year you contribute. Because you haven’t paid taxes on your 401(k) contributions, you will owe income taxes on your initial investment and any earnings when you withdraw that money in retirement.
Comparatively, you fund Roth IRAs with after-tax money. While it doesn’t give you a tax break this year, it allows you to withdraw tax-free after you reach age 59½ and have had the account for more than five years.
Many banks, brokerage firms and federally insured credit unions offer Roth IRA products. Keep in mind that each institution’s account requirements and fees vary. Understanding the rules and account fees is essential, so study the account documents provided before signing up.
After opening a Roth IRA, you decide where to invest your contributions among the options offered by your brokerage account or bank. You can choose to invest your Roth IRA contributions in multiple ways, including stocks, bonds, exchange-traded funds (ETFs), mutual funds, money market funds, certificates of deposit (CDs) and even cryptocurrency among other options.
Who can contribute to a Roth IRA?
Anyone with earned income can open a Roth IRA if they make less than the threshold set by the IRS. The IRS uses a formula based on your modified adjusted gross income (MAGI) to determine if you qualify.
Income limits
For people filing their taxes as single, head of household, or married, filing separately in 2022, the maximum you can earn and still contribute fully to a Roth IRA is $129,000. For people married filing jointly, the limit is $204,000. In 2023, the maximum will be $138,000 for single filers and $218,000 for people filing jointly.
Single filers earning between $129,000 and $144,000 in 2022 may still be eligible to save money in a Roth IRA, but the contribution limit is reduced. In 2023, single filers may be eligible if they earn between $138,000 and $153,000.
Those who are married, filing jointly, and earning between $204,000 and $214,000 in 2022 (or between $218,000 and $228,000 in 2023) may also be eligible to contribute at a lower rate.
You can’t contribute to a Roth IRA if you earn more than $144,000 as a single filer in 2022 or more than $214,000 for married people filing jointly. In 2023, you can’t contribute if you earn more than $153,000 as a single filer or more than $228,000 as a married couple, filing jointly.
Roth IRA contribution limits
In addition to income eligibility requirements, the IRS limits how much you can contribute to a Roth IRA each year. If you qualify to make a full contribution to a Roth IRA, you can contribute either 100% of your income or up to the contribution limit, whichever is less.
In 2022, the contribution limit is $6,000. For those over 50 years old, the contribution limit is $7,000, as a way to ‘catch up’ on retirement savings. In 2023, the limit will increase to a maximum contribution of $6,500, or $7,500 for those over 50.
You can have more than one IRA in your retirement portfolio. However, you can’t contribute more than the maximum contribution total across all individual retirement accounts. For example, if you are under age 50 and have two IRA accounts, you can put $3,000 into each, for a total of $6,000, the contribution limit in 2022, but you can’t max out both accounts.
Working with a financial planner or accountant can help you determine if you’re eligible to contribute to a Roth IRA.
How can I withdraw my money from a Roth IRA?
Withdrawals for a Roth IRA generally offer more flexibility than a 401(k) or traditional IRA, but you must follow a few rules:
- Account owners must be at least 59½ and have held the account for more than five years to avoid any penalty or taxes when taking distributions.
- You can withdraw your original contributions anytime without paying penalties or taxes.
- If you withdraw earnings from your account before you reach age 59½ and have owned the account for less than five years, you will have to pay taxes and a 10% early withdrawal penalty on your earnings. The IRS assumes you withdraw your original contributions first, followed by your earnings.
Qualified distributions
There are cases where you can withdraw earnings before age 59½ without penalty. The IRS calls these qualified distributions, and they can include:
- Buying or building your first home (up to a $10,000 lifetime maximum).
- Qualified education expenses.
- Paying health insurance premiums while unemployed.
- Disability-related costs if the distribution is made after the Roth IRA owner becomes disabled.
- Birth or adoption expenses.
Even though you may not have to pay the 10% penalty for qualified distributions, you’ll likely have to pay taxes. Make sure you understand all the rules and exceptions of qualified distributions before withdrawing funds. Otherwise you could face a hefty tax bill and penalty.
Benefits of a Roth IRA
Roth IRAs have several benefits worth considering in your retirement strategy. In addition to tax-free withdrawals when you meet the age and length of ownership requirements and the ability to withdraw your contributions without penalty or tax at any time, other Roth IRA benefits include:
- No age limits on contributions: As long as you have earned income, you can contribute to a Roth IRA at any age. Remember, you can’t contribute more than the total income earned or the set contribution limit, whichever is less.
- Flexibility: You can choose when and how much to contribute to a Roth IRA. Making the maximum contribution at the beginning of the year lets your money get to work for you longer. You can also break up your contributions on a set schedule to fit your budget.
- No mandatory withdrawals: Unlike other retirement accounts, Roth IRAs don’t have required minimum distributions that must be taken after you reach age 72. If you inherit a Roth IRA from a relative, you may be required to take minimum distributions. Work with a tax professional to help you develop a strategy that best fits your situation.
- No income tax for inherited Roth IRAs: If you leave your Roth IRA to your heirs in your will or estate plan, their withdrawals may also be tax-free as long as you held the account for at least five years before your death.
- Extra contribution time: The IRS allows you to contribute money into your Roth IRA for the previous calendar year up to that year’s tax deadline (usually April). For example, if you want to make 2022 contributions, you have until April 18, 2023, to do so.
Roth IRA drawbacks
- No current-year tax benefits: Unlike with a 401(k), there are no immediate tax benefits when contributing to a Roth IRA. While a 401(k) lowers your tax bill now, a Roth IRA’s benefits are delayed until retirement.
- Income limits and contribution limits: Only some are eligible to contribute to a Roth IRA. Those who are eligible can only contribute a certain amount each year.
- The five-year rule: To make tax- and penalty-free withdrawals from your Roth IRA, you must have owned the account for at least five years from when you made the first contribution and be at least age 59½. If you’re thinking of retiring soon and might open a new Roth IRA, consider the five-year rule in your planning.
- No automatic payroll deduction: Unlike traditional retirement accounts, Roth IRAs don’t allow you to make automatic payroll deductions. Instead, you must set up an automatic withdrawal from your bank account after your payroll has been deposited.
Bottom line
You fund Roth IRAs with after-tax money. It doesn’t have the same current-year tax benefits that a traditional retirement account has. However, it does let you withdraw funds without paying state or federal taxes after meeting specific requirements. Having both a pre-tax retirement account like a 401(k) and an after-tax retirement account like a Roth IRA can help you make the most of your retirement dollars. Work with a financial planner to help determine what retirement accounts work best for you, now and in the future.
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