How Does a Roth IRA Work?

Roth IRAs can offer a tax-advantaged way to save for retirement

A Roth individual retirement account (IRA) is a type of tax-advantaged retirement savings account that people with earned income can open. You can set up a Roth IRA in addition to a workplace retirement plan, or in place of one, if your employer doesn't offer a 401(k). 

How does a Roth IRA work? The Internal Revenue Service (IRS) has specific rules regarding contributions, withdrawals, and taxation. Understanding these guidelines can help you decide if a Roth IRA belongs in your retirement savings strategy. 

Key Takeaways

  • A Roth IRA is a type of tax-advantaged savings plan that people can use for retirement. 
  • Roth IRAs are funded with after-tax dollars and allow for tax-free qualified distributions. 
  • Whether you can contribute to a Roth IRA is determined by your annual income and tax filing status. 
  • Roth IRAs may be more attractive than traditional IRAs for people who anticipate being in a higher tax bracket in retirement. 

Roth IRA Tax Benefits

IRAs are designed to hold tax-advantaged retirement savings. Roth IRAs allow savers to set aside money for retirement using after-tax dollars. Unlike a traditional IRA, contributions to a Roth IRA are not tax-deductible. But savers can get the benefit of tax-free qualified distributions when they retire. There's no deadline for taking money out of a Roth IRA either, so you can leave the money in your account until you need to use it.

If you end up not needing to use the money in your Roth IRA for retirement, you can pass it down to one or more beneficiaries. The benefit of tax-free qualified distributions passes along to them as well. This could make a Roth IRA an attractive option for estate and financial planning, if you'd like to leave a legacy of wealth for your heirs. 

How Roth IRA Contributions Work

The IRS has certain guidelines in place that determine who can contribute to a Roth IRA and how much they can save each year. There are also rules for how long you have to make contributions and what kind of tax benefits you might enjoy. 

Who Qualifies To Make Roth IRA Contributions?

Your ability to make a full contribution to a Roth IRA is based on your tax filing status and modified adjusted gross income (MAGI). If your income is above the thresholds established by the IRS, you may not be eligible to save in a Roth IRA.

For 2022, you can make the full Roth IRA contribution if you:

  • Have a modified AGI of less than $129,000 and file single, head of household, or married filing separately and did not live with your spouse at any time during the year
  • Have a modified AGI of less than $204,000 and file a joint return as a married couple or file as a qualifying widow(er) 

Whether you have a 401 (k) plan at work doesn't matter for Roth IRA eligibility. You can open and save in a Roth if you have a workplace retirement plan, as long as you're within the income limits. 

If you're married and file separate returns but lived together during the year, you won't be eligible to contribute to a Roth IRA if your modified AGI is greater than or equal to $10,000.

How Much Can You Contribute to a Roth IRA?

The IRS sets the annual contribution limits for Roth IRAs. For 2022, the maximum annual contribution allowed is $6,000. If you're 50 or older, you can make an additional catch-up contribution of $1,000.

Roth IRA contribution limits are aggregate. So if you have multiple Roth IRAs, you can contribute money to all of them. But total contributions can't exceed the allowed annual contribution limit. 

The annual contribution limits for Roth and traditional IRAs follow the same guidelines. 

Deadline for Making Roth IRA Contributions

The IRS allows some leeway in how long you have to make Roth IRA contributions each year. Technically, you have until the tax filing deadline to make a contribution for that tax year.

So if you want to make Roth IRA contributions that count for 2022, for example, you'd have from Jan. 1, 2022, to the April tax filing deadline in 2023 to make them. When making contributions, you have to specify which tax year you want them to count toward. 

Retirement Saver's Credit for Roth IRA Contributions

Making Roth IRA contributions could help you qualify for the Retirement Saver's Credit. This credit is designed for lower- and middle-income earners who save money in eligible retirement accounts. 

For 2022, you're eligible for the credit if you're:

  • 18 or older
  • Not claimed as a dependent on anyone else's return
  • Not a student
  • Within income guidelines

The amount of the credit is 10%, 20%, or 50%, depending on your income and filing status. Here's how the credit works for 2022.

Credit Rate Married Filing Jointly Head of Household All Other Filers*
50% of your contribution AGI not more than $41,000 AGI not more than $30,750 AGI not more than $20,500
20% of your contribution $41,001- $44,000 $30,751 - $33,000 $20,501 - $22,000
10% of your contribution $44,001 - $68,000 $33,001 - $51,000 $22,001 - $34,000
0% of your contribution more than $68,000 more than $51,000 more than $34,000

Investing Roth IRA Funds

When you open a Roth IRA, one of the most important things you'll need to decide is how you want to invest your contributions. Depending on the brokerage that holds your Roth IRA, you may be able to invest in:

  • Stocks
  • Mutual funds
  • Index funds
  • Exchange-traded funds (ETFs)
  • Target-date funds
  • Bonds
  • Money market funds
  • Cash and cash equivalents

Brokerage firms can offer a choice between self-managed trading or automated investing. With self-managed investing, it's up to you to decide what investments to buy, how much to invest, and when to buy or sell. Automated, or “robo-advisor,” investing creates a portfolio for you automatically, based on your risk tolerance, age, and goals. 

If you're more hands-on with investments, you might choose the self-managed route. On the other hand, if you're just starting out with retirement investing, you might prefer an automated approach. 

Consider the expense ratio of different mutual funds, as this can tell you how much it'll cost you to own the fund on a yearly basis. 

With either strategy, it's important to understand how the value of your Roth IRA grows over time. Your balance can increase as you make new contributions but your investments can yield growth as well. For example, you might earn interest from bonds or bond funds or dividends from stocks or mutual funds that get reinvested. 

Keep in mind that your account balance can go up or down over time as the value of your investments fluctuates. Diversifying with varied types of investments can help smooth out the bumps and manage risk. There's no right or wrong strategy for creating a diversified portfolio

Roth IRA Withdrawals

How do Roth IRA withdrawals work? Generally, Roth IRAs are designed to hold money that you don't plan to access until at least age 59 ½. This is the earliest you can withdraw earnings from a Roth IRA without triggering a 10% early withdrawal penalty.

Qualified Roth IRA Distributions

Qualified Roth IRA distributions are tax-free. According to IRS rules, a qualified distribution is defined as any payment or distribution that meets these requirements:

  • It's made after the five-year period beginning with the first tax year you opened and contributed to a Roth IRA.
  • It's made on or after you reach age 59 ½, because you're disabled, or because you qualify for another exception. 

If you make a distribution that doesn't fit these conditions, you'll likely have to pay the 10% early withdrawal penalty. You may also have to pay income tax if you're withdrawing earnings.

Original contributions from a Roth IRA can be withdrawn without penalty at any time, as long as you're not taking out any earnings. 

Roth IRA Five-Year Rule

For distributions to be qualified, the IRS imposes a five-year rule for Roth IRAs. This rule dictates that your account must be open for at least five years in order to avoid tax on withdrawals of earnings.

For example, say you just turned 59 ½ and you want to withdraw $100,000 from your Roth IRA. Of that amount, $15,000 is earnings on your investments. If you opened the account at age 54, then you'd pass the five-year rule requirement. But if you just opened your Roth IRA at age 57, you'd be within the five-year window, meaning you'd owe tax on the earnings. 

Because you're 59 ½, the 10% early withdrawal penalty would not apply. 

Roth IRA Early-Withdrawal Exceptions

As mentioned, the minimum for withdrawing money from a Roth IRA is 59 ½ if you want to avoid a tax penalty. There are, however, some exceptions to this rule. For example, you can take money out of your Roth IRA early and avoid the penalty if:

  • You become totally and permanently disabled
  • You're the beneficiary of a deceased IRA owner
  • You're withdrawing money toward the purchase of a first home
  • Distributions are part of a series of substantially equal payments
  • Distributions are used to pay unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (AGI)
  • You're withdrawing money to pay medical insurance premiums while unemployed
  • You're withdrawing money to pay qualified higher-education expenses
  • Distributions are required to satisfy an IRS levy
  • You're receiving qualified reservist distributions

If you're taking money from a Roth IRA to buy a home, the exception to the 10% early withdrawal penalty applies to the first $10,000 that's distributed. If you're using money in a Roth IRA to pay for higher education, the amount withdrawn cannot be greater than the amount needed to cover those expenses. 

No RMDs for Roth IRAs

With a traditional IRA, you're required to begin taking money from your account at age 72. These withdrawals are called required minimum distributions (RMDs)

Roth IRAs have no RMDs, meaning you don't have to take money from your account if you don't want to. As long as you're still working and earning income, you can keep contributing to your account indefinitely.

Those who inherit a Roth IRA may still be subject to RMD requirements. 

Frequently Asked Questions (FAQs)

How does a backdoor Roth IRA work?

A backdoor Roth IRA works by allowing investors to convert a traditional IRA to a Roth account. Tax is due on the conversion at the time it's completed, but future distributions from the converted Roth IRA would be tax-free. 

How does a spousal Roth IRA work?

A spousal Roth IRA allows a non-working spouse to save for retirement without having earned income. The working spouse can use their income to open and fund a Roth IRA for their spouse. The assets in the account belong to their spouse for use in retirement.

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