What Is a Roth IRA? What You Need to Know

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Updated on Monday, September 28, 2020

When it comes to saving for your golden years, Roth IRAs are one of the most popular accounts out there. They combine many of the tax advantages retirement plans are famous for, along with the flexibility of being able to open one on your own instead of through your employer. This article covers everything you need to know about Roth IRAs.

What is a Roth IRA?

A Roth IRA is an individual retirement account that offers tax-free withdrawals in your retirement years. With a Roth IRA, you invest your already-taxed dollars in an investment account, where it has the potential to grow tax-free over the years. Once you reach the age of 59 1/2 and your account has been open for at least five years, you are able to withdraw your funds, tax-free.

How does a Roth IRA work?

  • It’s an account you open on your own, not through your employer. Unlike retirement plans that you can sign up for through your employer — 401(k) plans, for example — Roth IRAs are individual retirement plans that you open on your own. Most big banks and brokerage firms like Fidelity, Charles Schwab and Vanguard offer Roth IRA products with low minimum deposits and minimal fees.
  • It’s an investment account, not a savings account. When you open a Roth IRA, you’re investing your money rather than stashing it in savings. How much your investments gain — or lose — will depend on how you invest your funds. When opening a Roth IRA, your broker typically lets you choose an investment strategy based on your risk tolerance and age. Your Roth IRA may consist of ETFs, mutual funds, individual securities, stocks, bonds, U.S. Treasuries, annuities and even FDIC-insured CDs.
  • You have to pay taxes on your contributions. One of the core components of Roth IRAs is that they are funded with after-tax dollars, meaning you have to pay taxes on the money you contribute.
  • Your contributions and earnings grow tax-free, and are withdrawn tax-free. The chief benefit of Roth IRAs comes into play when it’s time to withdraw. Your contributions and earnings that compound and grow within your Roth IRA are able to do so tax-free, and you won’t have to pay taxes on the funds you withdraw. This is why Roth IRAs are often considered a great option for those who anticipate being in a higher tax bracket in the future — you’ve already paid taxes on the money you’re taking out, but at a lower rate.
  • There is no limit to how long you can contribute. The beauty of Roth IRAs is that there is no deadline as to when you are required to stop contributing. However, there are rules when it comes to contributions and withdrawals — which we dig into later in this article.

Roth IRA benefits

As a retirement savings vehicle, Roth IRAs offer a plethora of benefits including:

  • Tax breaks. The key benefit of Roth IRAs are the tax advantages they provide: Your earnings can grow tax free and you’re allowed qualified, tax-free withdrawals in your golden years.
  • No RMDs. Unlike other retirement plans, Roth IRAs stand out for the fact that they don’t require you to begin taking required minimum distributions (RMDs) once you hit a certain age. If you don’t want to be on a timeline for withdrawals, Roth IRAs are a good option for you.
  • No taxes for beneficiaries. If you want to pass down your Roth IRA to a beneficiary, they will benefit from being able to make tax-free withdrawals. It’s worth noting, though, that inherited Roth IRAs are subject to RMDs.
  • More lenient early withdrawal rules. Compared to other retirement plans, Roth IRAs are a bit more lenient when it comes to early withdrawals. IRA-specific exceptions to the early withdrawal penalty are relatively numerous and relevant: Medical bills or health insurance premiums, for example. In addition, you’re able to withdraw contributions (though not earnings) from your Roth IRA at any time, tax-free and penalty-free.

Roth IRA contribution limits

The IRS caps how much you’re allowed to contribute to your Roth IRA per year. For 2021, your contributions to both your traditional and Roth IRA (combined) cannot exceed:

  • $6,000 for those under 50
  • $7,000 for those 50 and older

In addition to how much you’re able to contribute to your Roth IRA, there are also rules as to who can contribute to a Roth IRA, based on income. In general, high-earners typically cannot contribute to a Roth IRA, or are capped at how much they can contribute annually. One way to get around this rule is through a backdoor Roth IRA. A backdoor Roth IRA is when you contribute to a traditional IRA (which does not have income limits) and then convert it to a Roth IRA. There are tax implications to this strategy, though, that are certainty worth considering.

Roth IRA income limits are based on your modified adjusted gross income; for 2021, the income limits are as follows:

Filing statusEligible to contribute up the full amountEligible to contribute reduced amountNot eligible to contribute
  • Single
  • Head of household
  • Married but filing separately (if you did not live with your spouse during the year)
Less than $125,000Income of $125,000 to $139,999.99Income of $140,000 or more
  • Married filing jointly
  • Qualified widow(er)
Less than $198,000Income between $198,000 and $207,999.99Income of $208,000 or more
  • Married filing separately (if you did live with your spouse)
N/AIncome up to $9,999.99Income of $10,000 or more

Any contributions you make must be made with what the IRS considers “earned income,” (such as wages, salaries, tips or commissions). That means the following types of funds are not eligible for a Roth IRA:

  • Earnings and profits from properties
  • Interest and dividend income
  • Pensions or annuity income
  • Unemployment income
  • Social Security

However, one exception to this rule is the Roth spousal IRA. A Roth spousal IRA allows a working spouse to make contributions on behalf of a nonworking spouse.

Roth IRA withdrawal rules

While Roth IRAs do come with the major benefit of not having to make required minimum distributions — meaning you don’t have to start making withdrawals at a certain age — you do have a few rules that you must follow.

In order to reap the core benefit of a tax-free and penalty-free withdrawal, you have to be at least 59 1/2 years old and have had the Roth IRA for a minimum of five years. Exceptions to the early withdrawal penalty include:

  • Qualified higher-education expenses
  • First-time home purchases
  • Medical expenses
  • Disability claims
  • Health insurance
  • Substantially equal periodic payments
  • Involuntary distribution due to an IRS tax levy
  • Reservist distributions

Roth IRA vs. Roth 401(k)

A Roth IRA is not the only Roth iteration of a retirement plan — there’s also the popular Roth 401(k) option. The chart below outlines the main differences and similarities between a Roth IRA and a Roth 401(k).

 Roth IRA Roth 401(k)
Annual contribution limits $6,000 for those under 50
$7,000 for those 50 and older
$19,500 for those under 50
$26,000 for those over 50
Income requirements Income limits based on modified AGINo income limitations
Contribution taxationContributions are made with after-tax dollars Contributions are made with after-tax dollars
Withdrawal taxationContributions and earnings for qualified withdrawals are not taxed Contributions and earnings for qualified withdrawals are not taxed
Required minimum distributions NoneMust begin no later than 72 unless you’re still working or own less than 5% of the company for whom you work

Roth IRA vs. Traditional IRA

Roth IRAs are also highly-comparable to traditional IRAs, and while they share many of the same core features, they also have significant differences. The chart below stacks up the Roth IRA against the traditional IRA.

 Roth IRA Traditional IRA
Annual contribution limits $6,000 for those under 50
$7,000 for those 50 and older
$6,000 for those under 50
$7,000 for those 50 and older
Income requirementsIncome limits based on modified AGINo income limits
Contribution taxationContributions are made with after-tax dollars and are not deductible Contributions can be made with pre-tax dollars and are deductible
Withdrawal taxation Contributions and earnings for qualified withdrawals are not taxed Deductible contributions and earnings for withdrawals are taxed as regular income
Required minimum distributions NoneRequired beginning in the year you turn 72

How to open a Roth IRA

Opening a Roth IRA can be easily done at an online brokerage firm, robo-advisor, bank or other financial institution. While each financial intuition has its own set of instructions when opening a Roth IRA, you can expect to take the following steps:

  1. Determine your eligibility. Before opening a Roth IRA, make sure your income does not make you ineligible and that you have earned income to contribute.
  2. Select your account. With so many financial institutions offering Roth IRAs, the process can be daunting. You can check out our top picks for Roth IRA providers, in which we prioritized factors including fees, portfolio construction, customer service, research offerings, account minimums and firm reputation.
  3. Select your investments. After opening a Roth IRA, you have to tell your contributions where to go. Most Roth IRAs offer the option to either select a complete portfolio in a single fund (such as a target date fund) based on when you want to retire and your risk tolerance, or the ability to customize your own portfolio.
  4. Fund your account. Typically, you can fund your account with money from a check or a direct transfer from your bank account, funds that are rolled over from a 401(k) or from an existing IRA.

The “Find a Financial Advisor” links contained in this article will direct you to webpages devoted to MagnifyMoney Advisor (“MMA”). After completing a brief questionnaire, you will be matched with certain financial advisers who participate in MMA’s referral program, which may or may not include the investment advisers discussed.