Roth IRA: What It Is and How It Works

A Roth IRA is an effective way to save for retirement because of the tax benefits it offers. You can make contributions to the plan with after-tax dollars and withdraw the money tax-free when you retire.

The main difference between a traditional IRA and a Roth IRA is the way they’re taxed. With a traditional IRA, your contributions are tax-deductible, while with a Roth IRA, your qualified withdrawals in retirement are tax-free.

What Is a Roth IRA?

A Roth IRA is an individual retirement account to which you can make after-tax contributions to save for retirement. Your contributions to the account will continue to grow tax-free and you can make tax-free withdrawals once you reach the age of 59 ½.  

For many Americans, a Roth IRA, in combination with another retirement account like 401(k), is a part of their money management strategy for lower tax liability and retirement planning.

How Does a Roth IRA Work?

A Roth IRA can be funded with after-tax dollars. The money you contribute to the account should be from a qualified source of income, such as from a job. However, you can also fund the account with spousal contribution, conversion from a traditional 401(k) or IRA plan, or from a Roth 401(k) rollover.

The money you invest in the account can earn a return over the long term. The money you invested and the investment growth on it can be withdrawn tax-free. There are no required minimum distributions (RMDs) with a Roth IRA.

If you need to withdraw the money from your account before you reach retirement, you can only withdraw your contributions without additional penalties or taxes.

Investment Options Within a Roth IRA

There are several types of products you can invest in your Roth IRA, such as:

• Individual bonds and stocks
• Index funds
• ETFs
• Mutual funds

A Roth self-directed IRA (SDIRA) will offer you the largest range of investment options. With this type of IRA, you’ll manage your own investments. Other than the standard assets, you can also hold assets like tax liens, partnerships, investment real estate, and gold in this type of Roth IRA.

Benefits of Investing in a Roth IRA

There are a number of benefits of investing in a Roth IRA:

• There are no age restrictions, so you can contribute at any age if you have a qualifying income.
• Your contributions can grow tax-free in the account.
• Withdrawals can be taken out penalty-free and tax-free if you’re at least 59 ½ years old and have met the minimum holding period.
• You’re not required to take the required minimum distributions.

How To Open a Roth IRA Account

Here are the step-by-step directions on how to open a Roth IRA:

1. Check to make sure you’re eligible to open a Roth IRA account.
2. Decide where to open your account.
3. Compare investment companies and brokerages to find an account with low account minimums, low fees, and a wide range of investment options.
4. Fill out the paperwork online or in person and provide the necessary documents, such as your driver’s license, Social Security number (SSN), banking information, and beneficiary details.
5. Choose your investments. You can design your own portfolio, get help from a financial consultant, or purchase life-cycle or target-date funds.
6. Decide on a contribution schedule. You can either make an annual contribution or set up monthly transfers to your Roth IRA.

Eligibility Requirements for Roth IRA

Anyone with a qualified earned income is eligible to open a Roth IRA. However, you’ll also have to follow the contribution rules. The amount you can contribute depends on your modified adjusted gross income (MAGI) and filing status.

We’ve provided more information about the contribution limits and income restrictions below.

Rules and Regulations of Roth IRAs

The IRS announces the limits and amounts for Roth IRA contributions as well as eligibility requirements for the next tax year in the fourth quarter of each year.

Roth IRA Contribution Limits

The contribution limits for a Roth IRA depend on your tax filing status and modified adjusted gross income (MAGI). Here’s how much you can contribute in 2024.

Roth IRA Income Restrictions

The IRS sets income restrictions for Roth IRAs to limit high earners. In 2024, you can contribute the maximum amount, which is $7,000, if you’re single and your MAGI is less than $146,000. The amount you can contribute reduces as your income goes up, with the maximum income limit of $161,000.

If you’re married and filing jointly, you can contribute the maximum amount if your income is less than $230,000, with the contribution phasing out at a maximum income of $240,000.

If you’re age 50 or older, the maximum amount you can contribute is $8,000.

Roth IRA Withdrawal Rules and Penalties

You can withdraw your Roth contributions without early withdrawal penalties or taxes at any time. There are no required minimum distributions for a Roth IRA.

However, if you want to withdraw your earnings, you need to be at least 59 ½ years old and must have owned your account for at least five years to avoid paying taxes or penalties, as per the five-year rule.

Here’s how your withdrawals from a Roth IRA are treated if you meet the five-year rule:

• If you’re younger than 59 ½, your earnings are subject to penalties and taxes. However, you can avoid the penalties and taxes if you have a permanent disability or use the money for a first-time home purchase. Your beneficiary can avoid taxes on distribution if you pass away.
• If you’re 59 ½ or older and meet the five-year rule, there are no penalties or taxes.

If you don’t meet the five-year rule:

• Your earnings are subject to penalties and taxes if you’re younger than 59 ½. You may be able to avoid the penalty if you use the money for qualified purposes, such as first-time home purchase, permanent disability, unreimbursed medical expenses, and education expenses. However, you’ll still have to pay taxes on withdrawals. Your beneficiary can avoid penalties on distribution if you pass away.
• If you’re 59 ½ or older, you’ll have to pay taxes on withdrawals but no penalty.  

What Is a Spousal Roth IRA?

You can also contribute to a Roth IRA on behalf of your spouse, who earns little or no income. Roth IRAs can’t be joint accounts, so a spousal Roth IRA has to be held separately. Contributions are subject to the same limits and rules as any other Roth IRA account.

You must meet the following requirements to be eligible for spousal Roth IRA contributions:

• You must be married.
• You must be filing a joint tax return.
• You must have a qualifying source of income to make contributions.
• Your contributions can’t exceed the contribution limits.
• The total contribution for both spouses shouldn’t exceed the taxable income you report on your joint tax return.

Roth IRA vs. Traditional IRA

The main difference between a traditional IRA and a Roth IRA is the way they’re taxed. Traditional IRAs are funded with pre-tax dollars. A Roth IRA gives you a tax break when you make withdrawals in retirement.

You can have both types of accounts at the same time, depending on your retirement plans and contribution strategy. If you would like to reduce your taxable income and want a tax break in the present, a traditional IRA will be a better choice. A Roth IRA is a better choice if you want tax-free income when you retire.

Boost Your Retirement Savings With Roth IRA

A Roth IRA allows you to take qualified distributions tax-free and penalty-free after age 59 ½ if you’ve owned the account for at least five years. You can withdraw your contributions at any time without taxes or penalty.

Roth IRAs are funded with after-tax money, so you won’t get an immediate tax break. However, you’ll get access to a tax-free source of income when you retire if you meet the withdrawal criteria. If you think you’ll be in a high tax break when you’re older, a Roth IRA is a good choice since the money isn’t taxable.