What is a Roth IRA and why should I get one?

If you’re saving for retirement you may have heard about the Roth IRA or even been advised to open one, likely due to its tax incentives. A Roth IRA is a retirement savings account funded with your after-tax dollars, so you won’t have to pay taxes on the money you withdraw in the future, if you’ve followed the contribution guidelines.

Roth IRAs offer flexibility with investment options and you can keep the account open indefinitely. The tax advantages can greatly benefit you, especially if you retire into a higher tax bracket, which is common for many people, as they delay retirement and continue to work.

For the 2020 tax year, the maximum annual contribution limit is $6,000 for those under age 50, and $7,000 for those 50 years-old and up. This contribution limit is the same as it was in 2019.

In this article:

• How does a Roth IRA work?
• How to open a Roth IRA
• How much can I contribute to a Roth IRA?
• How much does a Roth IRA earn?
• Benefits of a Roth IRA
• Should I get a Roth IRA?

How does a Roth IRA work?

A Roth IRA, or individual retirement account, is an alternative to a work-sponsored retirement account, like a 401(k) or 403(b).You’ll have to open and contribute to a Roth IRA on your own. (More on that later.)

Contributions to a Roth IRA are made with after-tax dollars — you’ll make your contribution amount with income that’s already been taxed, according to your income tax bracket designated by the IRS. Unlike a traditional IRA or a standard 401(k), which is funded by pre-tax dollars, contributions to a Roth IRA are not tax-deductible.

However, because you’ve already paid income tax on your Roth contribution, the money in your Roth IRA will grow tax-free. That means you’ll have a stream of tax-free income in retirement.

For example, if you make an annual contribution of $5,000 for thirty years with a 4% rate of return, your Roth account balance will be $303,000.

You can also bequeath your Roth IRA to your heirs, who will receive it free of income tax, or name a trust the beneficiary.

Roth IRA withdrawal rules

With a Roth IRA, you can actually withdraw contributions at any time without any financial repercussions — but withdrawing any earnings could result in fees or penalty based on your age and how long you’ve had the account. Withdrawing from a Roth IRA is calling taking a distribution.

For example, if you’re younger than 59 ½ years old and owned the account for less than five years, you may have to pay both income taxes and a 10% additional penalty on any withdrawn earnings.

There are some exceptions that allow you to withdraw your earnings before age 59 ½ without penalties, such as a withdrawal for a first-time purchase of a house, a qualified education expense, or a disability-related withdrawal.

How to open a Roth IRA

You can open a Roth IRA at a bank, credit union, an asset-management company, or online brokerage.

You must contribute to your Roth IRA with earned income. That means if your income is comprised of rent payments, investment income, Social Security benefits, or unemployment wages you cannot use that income to contribute to a Roth IRA.

In order to contribute to a Roth IRA, you must meet a few income eligibility requirements. The income levels are based on modified adjusted gross income (MAGI).

Single and head of household tax status

As of 2020, if you file taxes as an individual or head of household, you contribute the full amount to your Roth IRA if your modified AGI is less than $124,000. You can contribute a partial or reduced amount if your MAGI is between $124,000 and $139,000. If your MAGI is $139,000 or more, you can’t contribute anything.

Learn more about the different types of tax filing statuses.

Married filing jointly and qualifying widow(er)

As of 2020, if your taxpayer status is married filing jointly or qualifying widow(er), you can contribute the full amount to your Roth IRA if your MAGI is less than $196,000. If your MAGI is between $196,000 and $206,000, you can contribute a partial or reduced amount. If your MAGI is $206,000 or more, you can’t contribute any amount.

Married filing separately

As of 2020, if your taxpayer status is married filing separately and you lived with your spouse for any amount of time during the tax year, you can contribute a partial or reduced amount — but not the full amount — to your Roth IRA if your modified AGI was less than $10,000.

If you did not live with your spouse during the tax year, you can contribute the full amount if your MAGI was less than $124,000; a partial or reduced amount if your MAGI was between $124,000 and $139,000; and nothing if your MAGI was $139,000 or more.

What if my income exceeds the Roth IRA contribution limits?

If your earnings exceed these income limits, you may still be able to contribute to a Roth IRA account through a backdoor Roth, or a once-per-year conversion from a traditional IRA.

How much can I contribute to a Roth IRA?

Annual contributions are capped for both traditional and Roth IRAs across all accounts. For 2020, the IRA contribution limit is $6,000 if you’re under 50 years old, and $7,000 if you’re 50 years old and over. (No change from 2019.) You can contribute to a Roth at any age, as long as you meet the income qualifications, unlike the traditional IRA, which can’t be contributed to after you’re 70½ years old.

Your contribution amount can only be as much as your earned income. For example, if your earned income for the year was $4,000, then you can only contribute $4,000 at maximum .

If you’re higher-income earner making a partial contribution, you can calculate the exact reduced amount you are allowed to give from the IRS’s own formula.

Contribute to your Roth IRA account through any of the following:

• Deposits from your bank. Usually made through an ACH transfer. (Learn more about transferring money).
• Spousal transfers. Open up a plan for a non-working spouse and fund their account.
• Rollovers. Direct the funds of your Roth IRA from one account to another.
• Conversions. Change, or convert, your funds from a different type of retirement account (like a 401(k) or traditional IRA) into a Roth IRA.

How much does a Roth IRA earn?

A Roth IRA doesn’t have a fixed interest rate. Instead, how much your Roth IRA earns depends on your investments. When your assets increase in value, you’ll get a higher return on your investment.

Your Roth IRA might not automatically make investments for you, so you’ll have to choose which securities to purchase, otherwise your money will gain only a small amount of interest by sitting in the account. A Roth IRA’s flexible investment options include:

• Stocks
• Bonds
• ETFs
• CDs
• Mutual funds
• Money market funds

Investments made with your Roth IRA may fluctuate, and could even lose money. Some types of investments are riskier than others; bonds are low risk, while stocks have a higher risk. But, because your retirement is years away, you should be able to recoup these losses in the long run.

Based on your risk tolerance,(how much you’re willing to lose), you should diversify your portfolio, or spread out the risk among investment types, either by yourself, through a financial planner, or even through a robo-adviser that invests your money based on algorithms. Offered by newer online brokerages, this automated process might appeal to people who prefer a hands off approach to investing.

Benefits of a Roth IRA

The biggest advantage of having a Roth IRA are the tax-free withdrawals. If you follow the guidelines, after age 59 1/2 you can withdraw contributions and any investment earnings without paying a cent of tax on them.

Another advantage to the Roth IRA: there are no required minimum distributions (RMDs). You can keep your Roth account for as long as you want, while a traditional IRA will force you to withdraw money starting at age 70 ½, which can prove unfavorable if you wanted your investments to continue growing.

Traditional IRA vs Roth IRA

At a glance, the chart below demonstrates the broad features and the differences between a traditional IRA and Roth IRA. The income and contribution limits set by the IRS are subject to change on a yearly basis.

You can own both a traditional IRA and Roth IRA, but remember that the contribution limit still applies as a total for all accounts. For example, you might contribute $2,000 to your Roth IRA, and $4,000 to your traditional IRA for the 2019 calendar year.

Additionally, you can own both an IRA and a 401(k), which has a different contribution limit. For 2020, the maximum contribution you can make to a 401(k) is $19,500, plus an additional $6,500 catch-up contribution if you're over 50 years old. (In 2019, the 401(k) contribution limit was $19,000, with a catch-up contribution of $6,000 if you were over 50.)

Should I get a Roth IRA?

Whether a Roth IRA is best for you depends on whether you'd benefit from a tax break now or later. It requires a little guesswork, namely when will you withdraw the money in the future, and whether or not you think you’ll be in a higher tax bracket at that time.

For example, if you choose to open a Roth IRA in your 20s when you make $35,000, and withdraw when you have a six-figure salary in your 60s, you’ll have effectively saved on income taxes. That’s because you went from a lower income tax bracket to a higher one.