What is a Roth IRA? How Do They Work?

Investing
Updated: 6th Jan 2021
Written by Kim Pinnelli
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Roth IRAs have tax benefits that help most people, and they’re easier than you think to set up. If you think you’ll be in the same tax bracket during retirement, look no further than the Roth IRA.

Not sure if one is right for you? Keep reading to learn how Roth IRAs work.

What is a Roth IRA?

A Roth IRA is an Individual Retirement Account you can set up to save for retirement tax-free. You contribute after-tax dollars.

This means you don’t get the tax deduction in the year you contribute, BUT your earnings grow tax-free. If you wait to withdraw funds until you are 59 ½ years or older, you pay no taxes (in most cases).

How Does a Roth IRA Work?

Once you open a Roth IRA, you make contributions when and how you want. You can contribute up to $6,000 per year.

Since you already paid taxes on the funds, your earnings grow tax-free. Each year the $6,000 sits in the account and grows.

Your money grows without creating a tax liability, leaving you with more money in retirement.

Who is Eligible for a Roth IRA?

To qualify for a Roth IRA, you must have eligible income. This means you earn money by working for someone or own your own business. It doesn’t include money you make from investments, since that’s not ‘earned income.’ You did not work for it.

The only people who may not be eligible for a Roth IRA are high-wage earners. The IRS has certain limits based on your tax filing status and Modified Adjusted Gross Income.

For example, if you’re single, you may contribute as long as you make less than $125,000 a year. If you make between $125,000 and $139,999, you may contribute a smaller amount (less than $6,000), and if you make more than $140,000, you are ineligible.

Married filing joint taxpayers have limits too. If you make $198,000 or less, you may contribute the full amount; at $198,000 – $207,999, you begin to phase out, and at $208,000 you can’t contribute.

How to Open a Roth IRA

You can open a Roth IRA at most banks or with an online stock broker. Where you open an IRA depends on your goals.

If you want something conservative, open a Roth IRA at your local bank. If you’re going to invest in stocks and bonds, though, find an affordable broker.

You can open an account with a robo-advisor or standard brokerage firm – just watch the fees no matter what you choose.

You make contributions on your schedule whether it’s a lump sum or in smaller amounts. As long as you don’t exceed the annual maximum contribution limits, you’re safe.

How Much Can I Contribute to a Roth IRA?

In 2021, the Roth IRA contribution limits remained the same as in 2020. Taxpayers under age 50, may contribute up to $6,000 per year. Anyone over the age of 50 may make catch-up contributions of $1,000 for a total of $7,000.

Roth IRA Contributions

  • Transfers: Set up regular contributions from your bank account to your Roth IRA. Figure out what you can afford and set up automatic contributions, so you don’t have to worry about it.
  • Rollover Contributions: Rollover existing retirement income (in a traditional IRA) to a Roth IRA to offset the tax liability during retirement.
  • Regular Contributions: You can make contributions when you have the money and can set them up.
  • Spousal IRA Contributions: If you have a non-working spouse, you can contribute to his/her Roth IRA with your earnings.
  • Conversions: You can convert your entire traditional IRA into a Roth IRA to gain the tax benefits during retirement. You won’t pay a withdrawal penalty, but you will owe the taxes on the converted funds in the year you convert.

Roth IRA Advantages

  • Tax savings – If you think you’ll be in a higher tax bracket during retirement, you save because you pay the taxes on your contributions when you contribute. Your earnings and withdrawals are then tax-free.
  • Contribute when you want – You can make contributions at any time throughout the year as long as you don’t exceed the maximum allowed for the year.
  • Withdraw contributions at any time – You can withdraw your contributions (not earnings) without penalty or taxes.
  • No-tax during retirement – As long as you’ve had your Roth IRA for 5 years, you won’t pay taxes on any withdrawals made after age 59 ½.
  • There’s no age limit – You can open and fund a Roth IRA at any age.
  • There aren’t required minimum distributions – Unlike a traditional IRA, you don’t have to make withdrawals at a certain age since you already paid taxes on the contributions.
  • You can contribute until April 15 – You get a little extra time to make contributions for the previous tax year if you want to squeeze in a deduction for that year.

What is the Downside of a Roth IRA?

  • You pay taxes when you contribute – You don’t get a tax break on your contributions, so it’s hard to see the benefit at the time.
  • You must follow the income limits – If you make too much money, you can’t contribute.
  • The maximum contribution amount is low – You can only contribute $6,000 a year, which isn’t enough to achieve most retirement goals.

Can You Lose Money in a Roth IRA?

Like any investment, you can lose money in a Roth IRA. Usually, though, investors who are in it for the long-haul see their balance bounce back.

In general, the stock market goes full circle every 10 years. Since retirement funds are meant to be long-term investments, you should be able to ride out the storm and see a return on your investment.

Of course, there aren’t any guaranteed. Anyone can lose money in a Roth IRA unless they invest in a conservative bank savings product versus an investment vehicle.

Need an Investment Strategy? Check out our guide on dollar-cost averaging

Roth IRA Five-Year Rule

To take advantage of the Roth IRA tax-free withdrawals, you must have the account for at least 5 years.

For example, if you open the account at age 58 ½, you can’t make tax-free withdrawals at age 59 ½ (the typical retirement age). Instead, you must wait until you are 63 ½ years old for this benefit.

What is a Backdoor Roth IRA?

The Backdoor Roth IRA strategy applies to high-income wage earners who wouldn’t qualify for a Roth IRA. Because you make too much, the IRS won’t allow you to contribute to a Roth IRA, but you can contribute to a traditional IRA, so here’s how it works.

You open a traditional IRA and make your contributions. You write off the contributions and take the tax deduction. Next, you convert your traditional IRA to a Roth IRA. You pay the taxes on the money you convert, and your earnings now grow tax-free in a Roth IRA.

Keep in mind, if you have your traditional IRA for a while and your contributions grew, you will owe taxes on the earnings and the contributions.

Roth IRA Early Withdrawals

In some cases, you can make a Roth IRA early withdrawal. Whether you pay taxes on the earnings or not depends on how long you have had the account.

If you’ve had it for more than 5 years, you pay no taxes. If you’ve had it for less than 5 years, you’ll pay taxes, but you can avoid the penalty in either case if you use the funds for any of the following:

  • Withdraw up to $10,000 to buy your first home
  • Pay for qualified medical expenses
  • Pay for qualified education expenses
  • Pay qualified expenses for a birth or adoption
  • You become disabled

Roth vs Traditional IRA

A traditional IRA provides tax benefits in the year you contribute. Because you get the relief right away, though, you pay taxes when you withdraw the funds in retirement. You’ll pay taxes on both the contributions and earnings.

Because of the tax-deferral traditional IRAs offer, the IRA has Required Minimum Distributions you must follow if you haven’t made withdrawals by the age of 70 ½.

A traditional IRA is better for those who think they’ll be in a lower tax bracket when they retire than they are in the year they contribute.

Learn More: Roth IRA vs Traditional IRA

Are Roth IRAs Safe?

Roth IRAs are safe and are a great way to offset tax liabilities if you know you’ll be in a higher tax bracket when you retire. It’s not easy to predict, but some people know this is the case and take advantage of the tax break the Roth IRA offers.

Bottom Line: What is a Roth IRA?

It’s easy to open a Roth IRA or to convert to one from a traditional IRA. The key is to save for retirement now, preparing yourself for the future.

If you can’t choose between a traditional or Roth IRA yet, invest in one and make changes down the road if necessary. The key is to lock in the savings and get your money growing as early as possible.

Kim Pinnelli
Kim Pinnelli
Kim is a personal finance expert with a Bachelor’s degree in Finance from the University of Illinois at Chicago. She has been freelance writing for 13 years for a number of large publications. Kim thoroughly enjoys helping people take charge of their personal finances.