Roth IRAs are popular individual retirement accounts. Contributions are made with after-tax dollars, which then grow tax-free. Withdrawals in retirement are also tax-free, making the account a great source of retirement income. By contrast, traditional IRA contributions are tax-deductible, so you’ll lower your tax bill now but you’ll pay taxes when you withdraw the money in retirement.
Roth IRAs offer a lot of perks compared to other retirement accounts. Understanding these perks and how they could benefit you can help you decide whether a Roth IRA is right for you.
- Funds in a Roth IRA grow tax-free and can be withdrawn tax-free in retirement.
- Early withdrawals from a Roth IRA are more flexible than they are from many other retirement accounts.
- Roth IRAs don’t require minimum distributions, so you’ll have more control over your withdrawals.
- A Roth IRA isn’t the best choice for everyone. Before opening an account, consider the tax implications and income restrictions.
Tax-Free Growth With a Roth IRA
The greatest benefit of a Roth IRA is that the money in the account can grow completely tax-free. You don’t pay taxes on any activity in the account, meaning there are no taxes on any capital gains or dividends you might receive from your investments.
Other retirement accounts such as a 401(k) or a traditional IRA provide the same benefit while the money remains in the account, but you’ll pay taxes when you eventually withdraw funds from the account.
With a regular investment account, you’d have to pay taxes on dividends and capital gains. This can slow down the growth of your portfolio because you may have to use some of your investments to pay those taxes, which reduces the amount of money you have invested—and, in turn, the impact of compounding growth.
Roth IRA Withdrawals Are Tax-Free
What sets Roth IRAs apart from traditional IRAs and other retirement accounts is that the withdrawals you make from the account are tax-free. With a Roth IRA, you pay taxes on the money before contributing it, so you don’t pay taxes on the principal or earnings when you withdraw the funds.
Here’s a quick comparison. If you withdraw $10,000 from a traditional IRA, you must report that withdrawal as $10,000 in income. You’ll typically owe taxes on that income, which will reduce the amount you can actually use for living expenses or other purposes.
However, if you withdraw $10,000 from a Roth IRA, you owe no taxes. You can use the full amount for whatever you’d like.
Greater Flexibility for Early Withdrawals
When you contribute to a retirement account, you’ll enjoy tax incentives that help build your savings. But you’ll also face restrictions on how you can use the funds you’ve contributed.
With a traditional IRA or 401(k), you’ll typically need to wait until age 59 ½ before withdrawing money. Most withdrawals prior to reaching that age will incur a 10% penalty in addition to the taxes you owe, although there are some exceptions.
With a Roth IRA, you can withdraw the money you contributed to the account at any time without incurring taxes or penalties.
After you reach age 59 ½, you can begin withdrawing Roth IRA earnings as long as the account has been open for at least five years. If you’re younger than 59 ½, there are a few scenarios in which you can avoid taxes, penalties, or both on early withdrawals from a Roth IRA, even if it hasn’t been open for a full five years. For example, penalty-free withdrawals may be allowed to pay for a first-time home purchase, qualified education expenses, or medical expenses.
A Roth IRA Lets You Avoid RMDs
With a traditional IRA or 401(k), account holders must begin making annual required minimum distributions (RMDs) starting in the year after they turn 72. The size of these RMDs varies with the account holder’s age and the amount in their IRA or 401(k).
Being forced to make these withdrawals can make tax planning more difficult because you have less control over when and how much money you take out of the account. Because withdrawals from traditional retirement accounts count as income, making a large withdrawal in a particular year can mean paying a lot of taxes.
Roth IRAs have no RMD requirements for as long as the account holder remains alive, giving you more control over how to use the money in the account.
Should You Open a Roth IRA?
A Roth IRA is a good choice for many savers, but it works better in some situations than others.
When a Roth IRA Works Best
Investors pay taxes on money before contributing it to a Roth IRA, then pay no taxes on withdrawals. In contrast, traditional IRAs provide an upfront tax break in exchange for paying taxes on withdrawals in retirement.
What that means is that a Roth IRA may be a good choice for a younger saver with less income who is in a lower tax bracket. If they expect to be in a higher tax bracket later in life, choosing a Roth IRA will minimize the overall amount of tax they’ll pay.
Who Might Prefer a Traditional IRA
Because a traditional IRA offers an upfront tax incentive, people who earn higher incomes can save money by contributing to this type of account. If you expect to be in a lower tax bracket during retirement than you are when you make the contributions, using a traditional IRA is typically a better choice.
Roth IRA Restrictions
One thing to keep in mind is that there are restrictions on who can contribute to a Roth IRA.
The primary rule is based on your income. You must stay below a certain level of income to contribute to a Roth IRA. If your income exceeds a limit based on your filing status, the amount you can contribute starts to decrease until it reaches $0.
Here are the income limits for 2022:
|Filing Status||Full Contribution||Partial Contribution||No Contribution|
|Single or head of household||Less than $129,000||More than $129,000 but less than $144,000||$144,000 or more|
|Married, filing jointly||Less than $204,000||More than $204,000 but less than $214,000||$214,000 or more|
If you’re married and file separately, your income limits depend on whether you lived with your spouse for any portion of the year.
The Roth IRA contribution limit for 2022 is $6,000. An additional $1,000 catch-up contribution is allowed if you're age 50 or older.
To contribute to a Roth IRA, you must have earned income. You can’t contribute more to your Roth IRA than your taxable income for the year.
The Bottom Line
Roth IRAs are one of the best ways to save for retirement, especially if you’re in a low tax bracket. The opportunity to have your investment grow tax-free for decades can help you avoid paying thousands of dollars in taxes that you’d otherwise have to pay.
However, keep in mind that a traditional IRA may be a better choice for some people. If you’re not sure which retirement account is right for you, consider speaking with a financial advisor.
Frequently Asked Questions (FAQs)
How do you open a Roth IRA?
You can open a Roth IRA through most brokerage companies. Often, it’s a good idea to keep your Roth IRA at the same broker as your taxable brokerage account, if you have one. That can make it easier to contribute money and manage your portfolio.
How much money can you put in a Roth IRA?
You can contribute a maximum of $6,000 per year to IRAs. You can contribute the full amount to a Roth IRA or to a traditional IRA, or split that $6,000 between the two types of accounts. If you’re age 50 or older, you can contribute an additional $1,000 per year. Depending on your income, you may have additional limits on the amount you can contribute.
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Securities and Exchange Commission. “Individual Retirement Accounts (IRAs).”
Charles Schwab. “Roth IRA Withdrawal Rules.”
IRS. “Traditional and Roth IRAs.”