- IRAs – or Individual Retirement Accounts – are connected to you and do not involve your employer like a 401(k) does. One type of IRA is a Roth IRA.
- A Roth IRA – or Roth Individual Retirement Account – is a special kind of IRA that requires post-tax contributions, allowing you to avoid taxes when you withdraw earnings later. This is different from a Traditional IRA, which takes pre-tax contributions.
- Roth IRAs are frequently opened when someone wants to roll over their employer-sponsored account – such as a 401(k) – to their own retirement account
- Roth IRAs can be a great piece of your retirement savings, especially if you expect to be in a higher income tax bracket when you withdraw from your account in the future.
Pretty much everyone dreams about how they’ll spend their retirement, whether that means a daily visit to the pool or beach, plenty of time on the golf course or tennis court, or traveling the world. Individual Retirement Accounts – or IRAs – are one of the most popular tools people use to save for retirement. Put together, Americans have saved over $12.2 trillion in IRAs alone.
The two main types of IRAs are Traditional and Roth. Roth IRAs are a unique type of retirement account funded with after-tax contributions. That means you pay regular income taxes on contributions but don’t pay any taxes on future withdrawals.
Keep reading to learn why that may be a good thing for your finances and why a Roth IRA could be the right choice to help you reach that dream retirement.
What is a Roth IRA and how does it work?
Basically, a Roth IRA is an after-tax retirement account. Roth IRAs are frequently opened when someone transfers their 401(k) to their own IRA – this is called a rollover. When you contribute to a Roth IRA, you pay taxes up front on your contributions, but you won’t owe any income tax on your investment gains when you withdraw later – as long as you follow a few rules.
That’s different from a traditional IRA. With a traditional IRA and most other non-Roth retirement accounts, contributions are pre-tax. That means you don’t pay any taxes on the income the year you earn the income. Instead, you pay taxes on withdrawals in the future, ideally at a lower tax rate.
How do I fund my account?
You can put money into your Roth IRA in a few ways:
- Direct contribution: A direct contribution works kind of like a transfer between two bank accounts. If you have an existing Roth IRA, you can transfer funds from a connected bank or brokerage account.
- 401(k) Rollover: If you have an existing Roth 401(k), you can move funds directly into a Roth IRA. If you have a traditional 401(k), you have to rollover to a traditional IRA or go through a Roth IRA conversion.
- Roth Conversion: A Roth conversion turns pre-tax traditional IRA or 401(k) dollars into after-tax Roth IRA dollars. This requires paying taxes on the income the year of your conversion so that your future withdrawals can be tax-free.
Roth IRA contribution limits
Roth IRAs have some important rules and limits to know about. These are particularly important for high-income investors, as the amount you are allowed to contribute phases out over a certain income level.
Generally, Traditional and Roth IRA accounts have a combined annual contribution limit of $6,000 for anyone up to 49 years old. You can contribute $7,000 per year if you are 50 or older. This extra $1,000 is sometimes referred to as a “catch up contribution.” Unlike a traditional IRA, you can keep making contributions after you are 70 ½ years old.
Importantly, you can contribute the maximum to your IRA even if you contribute to an employer-sponsored 401(k). Again, there are some income and filing status restrictions specifically for Roth IRAs.
Here’s a look at how Roth contributions phase out for those with higher incomes: