What is a Roth IRA and how does it work?
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Updated: July 11, 2024
A Roth Individual Retirement Account (IRA) is a retirement savings account that allows individuals to contribute after-tax dollars and enjoy tax-free growth and withdrawals. Unlike traditional IRAs, contributions to a Roth IRA are not tax-deductible, but the earnings and withdrawals during retirement are generally tax-free.
Roth IRAs are an attractive option for those anticipating a higher tax bracket in retirement. The main advantages include growing investments tax-free and withdrawing funds without incurring taxes, provided certain conditions are met.
The Roth IRA was established by the Taxpayer Relief Act of 1997 and named after Senator William Roth. The aim is to encourage people to save for retirement by offering tax benefits. Contributions to a Roth IRA can be made at any age, as long as the individual has earned income, and there are no mandatory withdrawal requirements, allowing the funds to grow, indefinitely.
How does a Roth IRA work?
A Roth IRA allows individuals to contribute post-tax income to their retirement savings. The contributions are invested in various assets such as stocks, bonds, mutual funds and ETFs. The account grows tax-free over time, and withdrawals in retirement are also tax-free, provided certain conditions are met.
To qualify for tax-free withdrawals, the account must have been open for at least five years, and the account holder must be at least 59.5 years old. Roth IRAs also offer flexibility, as contributions (but not earnings) can be withdrawn at any time without penalty, making it a versatile tool for both retirement savings and emergency funds.
Roth IRA contribution limits
The contribution limits for Roth IRAs are determined by adjusted gross income (AGI) rather than gross income. Gross income is the total income earned, while AGI is the income remaining after specific deductions, such as student loan interest, contributions to traditional IRAs and certain business expenses.
Married filing jointly
| Adjusted gross income | Contribution limits |
|---|---|
| To contribute the full amount to a Roth IRA, the AGI must be less than $23,000 in 2024. For AGIs between $230,000 and $240,000, the contribution limit is gradually reduced. | The maximum contribution is $7,000 per year (plus another $1,000 in catch-up contributions for those 50 and older), but it phases out for incomes above the specified AGI range. |
Married filing separately
| Adjusted gross income | Contribution limits |
|---|---|
| The phase-out range for contributions is narrow. If your AGI is less than $10,000, you can make a reduced contribution. | The maximum contribution is $7,000 per year (including catch-up contributions for those 50 and older), but it phases out for incomes above the specified AGI range. |
Single filing
| Adjusted gross income | Contribution limits |
|---|---|
| Single filers can contribute the full amount if their AGI is less than $146,000. For AGIs between $146,000 and $161,000, the contribution limit is reduced. | The maximum contribution is $7,000 per year, plus the catch-up contribution for those 50 and older, gradually phasing out for incomes within the specified AGI range. |
Roth contribution tax savings
Be sure to track your Roth contribution history. You are allowed to withdraw contributions anytime with no taxes or penalties. But, the earnings on your contributions are a different story.
If you withdraw earnings from a Roth IRA before retirement, you may have to pay income tax, plus a 10% penalty. That's why it is so important to leave your funds in the account until you reach age 59.5, an age set by the IRS for retirement account withdrawals.
There are a few exceptions. You can withdraw up to $10,000 for a first-time home purchase without penalties but do have to pay tax. Using Roth IRA funds for qualified education expenses is also allowed.
There are a few other, less common allowed early withdrawals, including disability and paying for medical expenses.
Roth IRA taxes and penalties
Withdrawals from a Roth IRA are tax-free and penalty-free if the account has been open for at least five years and the holder is 59.5 or older. However, there are penalties for early withdrawals of earnings, typically a 10% penalty plus income taxes on the amount withdrawn.
Qualified distributions: Qualified distributions, such as those made after age 59.5 or due to disability, are tax-free. Withdrawals for first-time home purchases (up to $10,000) also qualify.
Non-qualified distributions: Non-qualified distributions of earnings may incur a 10% penalty and be subject to income tax. However, contributions can be withdrawn anytime without taxes or penalties.
How to open a Roth IRA
Opening a Roth IRA involves a few straightforward steps:
Step 1. Choose a provider: Select a financial institution or brokerage that offers Roth IRAs.
Step 2. Complete the application: Fill out the necessary forms, providing personal information and funding details.
Step 3. Fund the account: Make an initial deposit and set up a regular contribution schedule.
Roth IRA rules
Eligibility: Must have earned income and fall within the specified AGI limits.
Contribution limits: $7,000 per year, plus another $1,000 in catch-up contributions for those 50 and older.
Withdrawals: Contributions can be withdrawn anytime; earnings are subject to withdrawal rules.
Required Minimum Distributions (RMDs): None during the account holder’s lifetime.
Conversions: Traditional IRAs can be converted to Roth IRAs, but taxes must be paid on the converted amount.
Know before you open an account
Before opening a Roth IRA, ensure your income falls within the limits. For 2024, single filers must have an AGI below $146,000, and married couples filing jointly must have an AGI below $230,000.
Other important items to know:
Tax benefits: Contributions are made with after-tax dollars, so withdrawals in retirement are tax-free if conditions are met. This is beneficial if you expect to be in a higher tax bracket in the future.
Contribution limits: For 2024, the limit is $7,000 per year ($8,000 if 50 or older), including catch-up contributions.
Withdrawal rules: Contributions can be withdrawn anytime tax-free and penalty-free, but earnings are subject to rules and may incur taxes and penalties if withdrawn early.
Investment choices: Select a provider that offers a range of investment options aligned with your retirement goals. Consider fees, fund performance, and customer service.
When to make a Roth contribution
When I had a regular day job with 26 biweekly paychecks, I divided the total allowed annual Roth IRA contribution evenly across all paychecks. For someone who gets paid on the same schedule and wants to contribute the maximum $6,500 per year (the limit for 2023), that would be $250 per paycheck.
You can contribute at any time, however. As someone who is now self-employed, I make a lump contribution for the entire balance once per year. You can divide it up any way you choose. But remember that investing in your Roth IRA (or traditional IRA) on a regular basis is an important part of saving for retirement.
Contributions are allowed into the following year until tax day. For 2023, for example, you could have made contributions until April 15, 2024. But you had to get the contribution in before you file your tax return.
Who does a Roth IRA work best for?
A Roth IRA is generally best for people who are in lower-income tax brackets during their earning years than they expect to be during their retirement years. The idea is to pay the tax while you are in the lowest possible tax bracket.
A Roth IRA is also a good idea for people who don't have access to a retirement plan through work. Only 50% of Americans have access to a 401(k) plan. A Roth IRA is a great way to jumpstart your retirement savings, especially if you start investing at a young age.
Since the Roth IRA rules around withdrawals are more forgiving than other retirement accounts (for both early and regular withdrawals), a Roth IRA can also act as an absolute last-ditch emergency fund. Generally, the advice from financial advisors and experts is to never to withdraw money from retirement accounts before you need it. And that's good advice. But if something terrible befalls your finances, it is easier to get money out of a Roth IRA than other accounts.
Why you should consider a Roth IRA
Roth IRAs are great for most middle-class earners for a few reasons:
- The maximum isn’t crazy high. The annual maximum contribution limit of $6,500 is just large enough to add up quickly over time but just small enough that — with some adjustments — most people can hit it.
- No taxes in retirement. Most people like the Roth IRA because you pay the taxes upfront. So when it comes to your retirement years, you don’t have to worry about any taxes. The money you’ve saved in your account is 100% yours.
- This sure makes figuring out your retirement budget easy. You won’t need to worry about accounting for Uncle Sam’s cut. And knowing you can simply withdraw the money without having to fill out any more tax paperwork can be a load off your mind, as well.
- Easy to open. A Roth IRA is a basic retirement account you can find practically anywhere. Brokerages, companies, banks and credit unions offer these accounts. They’re very common, which means, for most people, they’re easy to open.
- You can even open up a Roth IRA online. I’ve opened two of these accounts, both entirely over the Internet.
Advantages of investing in a Roth IRA
You can withdraw your funds from a Roth IRA tax-free at any time if you made your first Roth IRA contribution at least five years ago and are at least 59.5 years old. You pay a penalty if you withdraw your money early. But you can take out funds without paying this penalty, if:
- You become disabled
- After your death, the distribution is made to a beneficiary of your estate
- You or someone in your family uses the money (up to $10,000) to buy a first home
By allowing for tax-free withdrawals in retirement, a Roth IRA helps account holders diversify their tax base in retirement. Of course, tax rules and regulations change, and they could change in the future. But for now, any contributions made to a Roth IRA can be withdrawn tax-free.
Roth IRAs are also not subject to required minimum distributions. This is a huge benefit if you don't need to withdraw funds from your IRA in retirement.
The SECURE Act passed at the end of 2019 provides advantages when a Roth IRA is passed on to a non-spousal heir. Your heir no longer needs to wait to withdraw the money, as was true prior to the passing of this new law. But the downside is that your heir must withdraw the full amount within 10 years.
Roth IRA vs traditional IRA
The key differences between a Roth IRA and a traditional IRA lie in tax treatment and withdrawal rules. Roth IRAs use after-tax contributions and offer tax-free withdrawals in retirement, while traditional IRAs use pre-tax contributions, providing tax-deferred growth but subjecting withdrawals to income tax. Additionally, unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs) during the account holder’s lifetime.
This is the opposite of a traditional IRA. With a traditional IRA, you pay tax on the withdrawals in retirement but not on contributions today. Because of its unique structure, Roth IRAs are best for younger investors with a long time horizon to retirement. Those who are closer to retirement usually get a better deal with a traditional IRA.
A Roth IRA is a type of brokerage account you can open with any major investment company and some banks. Just like a regular brokerage account, you can buy and sell exchange-traded funds (ETFs), mutual funds, stocks, bonds and other assets. But, unlike a regular investment account, you won't pay tax on profits when you withdraw as long as you follow IRS rules.
Take full advantage of this unique tax-saving retirement strategy
The first place most people should focus on investing is their 401(k) or similar. Make sure to take 100% advantage of any employer match. Once you reach that level, your traditional and Roth IRAs should be the next priority. If you reach the maximum there, go back to the 401(k) until you reach the limit.
I make sure to contribute the maximum for myself and my wife every year. That is one investment I'm sure we'll never regret.
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Chris Clark is freelance contributor with MoneyWise, based in Kansas City, Mo. He has written for numerous publications and spent 18 years as a reporter and editor with The Associated Press.
Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full time.
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