In a nutshell, a Roth IRA is a type of individual retirement account that you contribute money to. Your contributions are then invested, and your money grows tax-free. That’s right.
What makes a Roth IRA so appealing is that your contributions grow tax-free and your withdrawals are tax-free too.
Of course, there are some things to consider if you are looking at investment options for your retirement. Let’s take a look at how the Roth IRA works, the potential benefits, as well as potential downsides and limitations.
What is an individual retirement account?
An individual retirement account, otherwise known as an IRA, is a personal savings account with certain tax advantages.
Your tax advantages all depend on what type of IRA you choose to contribute to. There are many IRAs to choose from: a Roth IRA or a traditional IRA, or for employers/small businesses, a SEP IRA or SIMPLE IRA.
You then choose where your contributions are invested in, whether it’s in stocks, bonds, mutual funds, etc.
So, it’s not just a savings account. It’s actually an investment account.
The idea is that your contributions grow with your investments, allowing you more financial security for your retirement.
How does a Roth IRA work?
Roth IRAs offer tax-free growth and tax-free distributions because the money you will contribute is after tax dollars – because it is money from your earned income. It’s already taxed.
Since you’ve already been taxed, there’s no need to pay taxes on the money again.
Key Benefits of a Roth IRA
Roth IRAs can be especially beneficial to those who expect to be in the higher tax bracket, making tax-free withdrawals even more favorable.
No required minimum distributions (RMDs)
Roth IRAs don’t have required minimum distributions, otherwise known as RMDs. With traditional IRAs, you are required to withdraw a certain amount after you turn 72. Otherwise, you will be taxed and penalized on 50% of the amount of the required distribution.
You can withdraw money, tax-free and penalty-free, five years from your first Roth IRA contribution or once you turn 59 and a half.
No age limitations
There are no age limitations to contribute to a Roth IRA. You can be any age, retired or not, and continue to contribute to a Roth for as long as you live.
No taxes for beneficiaries
If you pass your Roth to any beneficiaries, their withdrawals will be tax-free too.
No employee-plan limitations
Even if you contribute to employee plans, like a 401(k), you can still contribute to a Roth IRA.
Limitations & Downsides
Before opening a Roth IRA, there are a few things you’ll want to consider.
Contribution limits
The maximum individual annual contribution for a Roth IRA is $6,000. If you’re 50 or older, your annual limit is $7,000. These annual contribution limits go for traditional IRAs as well.
Income ranges
Additionally, your income range must be within a certain amount in order to qualify for a Roth IRA. As of 2022, single individuals must have an annual income less than $129,000 in order to qualify to make full contributions, and less than $144,000 in order to make partial contributions.
Income taxes and penalties
If you withdraw investment earnings made from your Roth IRA earlier than age 59 and a half, you may be subject to income taxes and penalties.
Contributions are not tax-deductible
Unlike with the traditional IRA, your contributions to a Roth are not tax-deductible. That’s because your withdrawals will be tax-free.
Key Takeaways
- Roth IRAs are great for those expected to be in a higher tax bracket
- Consider the five year holding period to make qualified withdrawals – if you’re close to retirement, this may be a disadvantage to you.
- You can only contribute earned income to a Roth IRA
- Contributions grow tax-free and offer tax-free withdrawals
How do I open a Roth IRA?
If you’ve looked over your options for retirement accounts and are ready to contribute to a Roth IRA, opening an account is easy and quick.
Almost all brokerage firms, banks, and investment companies offer a Roth IRA.
You can easily apply to open a Roth online through any of these avenues.