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Roth IRAs Explained


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Key Takeaways

  • 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:

If your filing status is: And your modified Adjusted gross income is: Then you can contribute:
Married filing jointly Less than $198,000 Up to $6,000 (49 and under) or $7,000 (50 and older)
At least $198,000 but less than $208,000 A reduced amount
$208,000 or more Zero
Married filing separately and you lived with your spouse at any time during the year Less than $10,000 A reduced amount
$10,000 or more Zero
Single, head of household, or married filing separately and you did not live with your spouse at any time during the year Less than $125,000 Up to $6,000 (49 and under) or $7,000 (50 and older)
At least $125,000 but less than $140,000 A reduced amount
$140,000 or more Zero

If you fall into the reduced amount ranges, the IRS provides more information on how to calculate that amount.

When can I withdraw money from my Roth IRA?

You are eligible to withdraw your Roth IRA contributions anytime – contributions are the money you put into the account, not any investment gains. That is because you already paid taxes on them when you contributed. Your earnings, on the other hand, are subject to a few restrictions. As a general rule, you can make penalty-free earnings withdrawals from Roth IRA once you turn 59 ½ years old. That’s an exciting half-birthday gift to look forward to!

To get the Roth tax benefits, earnings must sit in the account for at least five years, even if you are over 59 ½. For example, if you contribute when you are 58, earnings from that specific contribution can’t be withdrawn until you’re 63. This is called the Roth 5 year rule.

However, there are a few exceptions that would let you withdraw early. If you use funds for a first-time home purchase, certain education expenses, expenses related to birth or adoption, or to pay for medical costs when unemployed, you may be able to avoid early without any penalties.

What taxes will I pay on withdrawals?

As long as your account is five years old and you’re at least 59 ½, your withdrawals should be tax-free!

Because qualified withdrawals are tax-free, you should consider opening a Roth IRA, especially if you’re younger and expect your tax bracket to be higher in the future. You are never technically too old to open a Roth IRA, but the benefit may not make as much sense when you’re older.

The long investment time horizon means you can save a bundle on capital gains taxes with a Roth IRA if you start early. If you are getting closer to retirement and have less time to invest, you may be better off with a traditional IRA.

Investing with a Roth IRA

Most people choose to put their Roth IRA in an investment account. With most Roth IRA accounts, you can choose a wide variety of investment types. That includes stocks, ETFs, mutual funds, bonds, and other assets. While most employer 401(k) accounts offer a limited menu of investments, most Roth IRA accounts don’t charge any recurring annual fees and let you pick from thousands of investments.

Many investors choose a self-directed Roth IRA where you pick your own investments and don’t pay any recurring or annual account fees. Some people are more comfortable with an automated (robo-advisor) Roth IRA that chooses an investment portfolio for you for a fee. Both can be great options, it just depends on your personal preferences and circumstances.

Can my spouse or kids inherit my Roth IRA?

Yes, you can leave your Roth IRA to your family or other loved ones. This is typically referred to as an Inherited Roth IRA. Your loved ones can benefit from the same tax benefits you did as an owner, they’ll just have to review a few rules before withdrawing.

Bottom line: Roth IRAs are an important part of retirement planning

A Roth IRA is one of several important accounts you can use to reach your financial goals. Alongside a 401(k) at your current employer, Roth IRA is part of a puzzle that fits together to help you live comfortably in your retirement years. When you contribute, you’re helping to secure your financial future – and your dream retirement!

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