A Roth IRA is a double-tax-advantaged retirement savings account that offers tax-free earnings growth and tax-free distributions. Given the limited opportunities for these tax advantages, opening a Roth IRA is a great way to become financially independent by retirement.
Understand what a Roth IRA offers and how it works before incorporating one into your retirement savings strategy.
What Is a Roth IRA?
A Roth Individual Retirement Account (IRA) is a retirement savings account into which eligible individuals can contribute post-tax dollars. Although account holders can't deduct their contributions from their taxable incomes, they generally pay no taxes on the growth of contributions or on earnings before retirement, or on qualified distributions from the IRA after retirement.
The account is particularly attractive to those who are ineligible for an employer-sponsored 401(k) plan (or a plan offering a matching contribution), or those who are able to save more for retirement than the 401(k) plan limit allows. There's no age at which account owners must begin to distribute money from their Roth IRA, making the account desirable for those who want to pass along wealth to their children or grandchildren.
- Alternate name: Roth Individual Retirement Account
- Acronym: Roth IRA
Although tax deductions aren't possible for Roth contributions, some taxpayers are eligible for the Retirement Savers Credit based on their adjusted gross income. This is an added incentive that the tax code provides for low- and middle-income taxpayers to increase their retirement savings and reduce taxes along the way.
How a Roth IRA Works
A Roth IRA functions as a traditional IRA, except that you pay into it with post-tax dollars (money after taxes have been deducted) and you can only contribute if your modified adjusted gross income (AGI) is less than a certain amount.
You can invest the contributions you make to a Roth IRA in assets of your choice, such as stocks, bonds, or mutual funds. The money you contribute to your Roth IRA won't reduce your taxable income, but contributions and the earnings on those contributions grow tax-free. In fact, you don't even have to report the earnings to the IRS.
You don't pay tax on distributions that are considered to be "qualified," even in retirement when you first tap your Roth IRA for income. Qualified distributions are those you take after you reach age 59½ and at least five years after the taxable year when you first contributed to the Roth IRA. Non-qualified distributions can be partially taxed, and, if taken before the age of 59½, you might pay an extra 10% in penalties on the distribution.
For example, assume that Linda is 35 years old when she opens a Roth IRA. She decides to contribute $6,000 in after-tax dollars annually, which she uses to buy investments that garner her a yearly return of 6%. She cannot deduct that $6,000 from her yearly taxable income, but her account will be worth $474,349 in 30 years, when she's 65. She won't lose any of that to taxes as long as she takes qualified distributions from the Roth IRA after the age of 59½. Her take-home savings would be the full $474,349.
You won't face the 10% penalty if the distribution is made if you are disabled, it's made to a beneficiary after your death, or it meets other exceptions detailed in IRS Publication 590-B.
How Much Can I Contribute to a Roth IRA?
Your maximum contribution to the account is the lesser of your taxable compensation for the year or $6,000, or $7,000 if you're 50 or older, for the 2019, 2020, and 2021 tax years. Taxable compensation includes wages, salaries, and net self-employment earnings, but it excludes interest or dividends.
You don't have to make the entire contribution at once—you can make many smaller contributions, as long as the total amount contributed doesn't exceed the limit for the year. You can even contribute to both a traditional IRA and a Roth IRA as long as the combined amount doesn't exceed the limit.
The amount you can contribute to a Roth IRA is further restricted by your modified adjusted gross income (MAGI) and your tax filing status. Roth IRA income limitations change each year. For example, single filers can make maximum Roth IRA contributions when their MAGI is less than $124,000 in the 2020 tax year, a reduced amount if their MAGI is less than $139,000, and no contribution at all with a MAGI of $139,000 or more.
Single filers can make the maximum contribution if their MAGI is less than $125,000 in 2021, a reduced contribution if their MAGI is less than $140,000, and no contribution with a MAGI of $140,000 or more.
Each Roth IRA contribution relates to a specific calendar year. You can make a contribution from January 1 of that year until the filing deadline for your tax return, which is normally April 15.
How to Get a Roth IRA
There are usually only a few forms to complete. Just have your Social Security number handy, as well as the Social Security numbers and addresses of any potential beneficiaries.
Alternatives to a Roth IRA
Consider first maximizing your contribution to your 401(k) if your income disqualifies you from contributing directly to a Roth IRA, or if you don't yet contribute much, if anything, to your employer-sponsored 401(k). You'll qualify for an upfront tax deduction, but you'll have to pay taxes on distribution because you pay into a traditional 401(k) with pre-tax dollars. Roth 401(k) contributions allow you to avoid paying taxes on distributions.
Similar to traditional 401(k) plans, traditional IRAs also accept pre-tax contributions from individuals at all income levels, up to the same contribution limits as Roth IRAs. Your deduction may be limited if you also participate in a 401(k) at work, however, and if your income exceeds certain levels. You can even use what is known as the "backdoor" Roth IRA strategy to convert traditional IRA contributions into Roth contributions, but you'll have pay taxes on the converted amount, as you'll be switching from a pre-tax to post-tax account.
- A Roth IRA is a double-tax-advantaged retirement savings account that lets you avoid taxes on earnings growth and distributions.
- It allows savers to exceed the annual contribution limit on a 401(k) or pass on assets to their heirs.
- Limits apply to contributions that are further reduced by your MAGI and tax filing status.
- The "backdoor" Roth IRA strategy gives high earners to bypass income limitations to using the account, but other alternatives include 401(k) plans and traditional IRAs.