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 Arrangement (IRA) is a retirement savings account to which eligible individuals can contribute post-tax dollars. Although account holders can't deduct their contributions from their taxable income, they generally pay no taxes on the growth of contributions or earnings on those contributions before retirement, or on qualified distributions from the IRA after retirement.
The account is particularly attractive to those ineligible for an employer-sponsored 401(k) plan (or a plan offering a matching contribution) or those able to save more for retirement than the 401(k) plan limit allows. Plus, 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
While 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 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 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 isn't tax-deductible, meaning it won't reduce your taxable income. But contributions and the earnings on those contributions grow tax-free. In fact, you don't even report the earnings to the IRS.
Even in retirement, when you first tap your Roth IRA for income, you don't owe taxes on distributions that are considered to be "qualified." Qualified distributions are those you take after you reach age 59.5 and at least five years after the taxable year when you first contributed to the Roth IRA. Non-qualified distributions may be partially taxed, and, if taken before the age of 59.5, you may 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 in 30 years, when she's 65, her account will be worth $474,349. As long as she takes qualified distributions from the Roth IRA after the age of 59.5, she won't lose any of that to taxes; her take-home savings will be the full $474,349.
You won't face the 10% penalty if the distribution is made because you are disabled, made to a beneficiary after your death, or meets other exceptions detailed in IRS Publication 590-B.
How Much Can I Contribute to a Roth IRA?
For the 2019, 2020, and 2021 tax years, your maximum contribution to the account is the lesser of your taxable compensation for the year or $6,000 ($7,000 if you're 50 or older).
You don't have to make the entire contribution at once—you can make many smaller contributions, as long as the total contributed does not 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. Taxable compensation includes wages, salaries, and net self-employment earnings, but excludes interest or dividends.
The amount you can contribute to a Roth IRA is further restricted by your modified adjusted gross income (MAGI) and tax filing status. Roth IRA income limitations change each year. For the 2020 tax year, for example, single filers can make maximum Roth IRA contributions when their MAGI is less than $124,000, a reduced amount if their MAGI is less than $139,000, and no contribution with a MAGI of $139,000 or more.
For the 2021 tax year, single filers can make the maximum contribution if their MAGI is less than $125,000, a reduced contribution if their MAGI is less than $140,000, and no contribution with a MAGI of $140,000 or more.
Moreover, 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 of your tax return—April 15, typically. The due date for 2019 contributions was moved back to July 15, 2020, due to COVID-19.
How to Get a Roth IRA
You can open a Roth IRA at nearly any bank or brokerage house, either online or in person. Opening a Roth IRA is a simple process, typically with help readily available.
Often, there are just 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
If your income disqualifies you from contributing directly to a Roth IRA, or you don't yet contribute much, if any, to your employer-sponsored 401(k), consider first maximizing your contribution to your 401(k). You can make traditional or Roth 401(k) contributions regardless of your income. But as you pay into a traditional 401(k) with pre-tax dollars, you'll qualify for an upfront tax deduction but will have to pay taxes on distributions. Roth 401(k) contributions will 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. However, your deduction may be limited if you also participate in a 401(k) at work and 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.