What Is a Roth IRA? Understanding How it works

What is a Roth IRA?

A Roth IRA is like a special savings account for your retirement. What makes it special is that your money can grow without the government taking a cut through taxes. The cool thing about Roth IRAs is that you can take out your money without having to pay extra taxes if you play by the rules. Unlike most other retirement accounts, when you retire and start using the money from your Roth IRA, the government won’t touch it with taxes.

Now, a Roth IRA isn’t a particular type of investment, like buying stocks or bonds. Instead, it’s like a container where you can put different investments. You get to choose what you want to put in there, like stocks, bonds, savings certificates, mutual funds, or exchange-traded funds (ETFs). Whether your Roth IRA grows or shrinks depends on how well these investments do. And if you’re feeling adventurous, you can even invest in unusual things like cryptocurrency if you go for a self-directed Roth IRA.

Here’s the catch, though: when you put money into a Roth IRA, you can’t use it as a tax deduction, which you can do with regular IRAs and 401(k)s. But, here’s the cool part: once you’re 59 1/2 years old and you’ve had your Roth IRA for at least five years, you can take out as much money as you want, and you won’t have to give the government a single penny. Since you put after-tax dollars into your Roth IRA, you can also take out the money you originally put in (not the extra money you earned) at any time without worrying about taxes or penalties. It’s like having a tax-free piggy bank for your retirement!

Roth IRA Eligibility

To put money into a Roth IRA, you need to earn money through things like your salary, hourly pay, bonuses, tips, income from working for yourself, or commissions from your work. These types of earnings are called “earned income.” However, money you make from investments, Social Security, retirement payouts, unemployment benefits, or alimony don’t count as earned income for this purpose.

Now, whether you can use a Roth IRA also depends on how much money you make. If your income is higher than a specific amount, which varies depending on your tax filing status and where you live, you can’t contribute to a Roth IRA directly. But there’s a way around this for high earners called a “backdoor Roth IRA.” This involves putting money into a traditional IRA first and then moving it into a Roth IRA. It’s allowed, but here’s the catch: you’ll need to pay taxes when you move the funds.

To figure out if you qualify for a Roth IRA, you’ll need to know your “modified adjusted gross income” or MAGI. To calculate your MAGI, you’ll first need to find your “adjusted gross income” or AGI. Your AGI and MAGI will usually be very close or the same. The IRS website says that your MAGI typically equals your AGI, plus any tax deduction you get for paying student loan interest.

Roth IRA income and contribution limits

Roth IRAs have some rules about how much money you can put in and who can contribute. First, there’s an income limit. If you make too much money, you can’t contribute to a Roth IRA at all. And even if you can contribute, there’s a maximum amount you’re allowed to put in each year. You’ve got to be careful not to go over this limit, or it’s called an “excess contribution.”

For 2022, the most you can put into a Roth IRA is $6,000, or if you’re 50 or older, you can put in up to $7,000. This extra $1,000 is called a “catch-up contribution.” It’s there to help folks who are getting closer to retirement to save a bit more.

Now, how much you can contribute depends on your tax filing status and MAGI. Following table tells you how much you can put into a Roth IRA based on these factors.

The income and contribution limits for Roth IRAs in the years 2022 and 2023

Benefits of a Roth IRA

Roth IRAs offer some great advantages, such as:

Tax-Free Retirement Income: With a Roth IRA, you can potentially save a ton on taxes in retirement. If you contribute regularly and your investments do well, you can take money out of your Roth IRA when you retire without having to pay any income taxes. This means big savings. Plus, if you need to make a major purchase in retirement, you won’t face a hefty tax bill or risk jumping into a higher tax bracket for that year.

First-Time Homebuyer Perk: If you’re buying your first home and neither you nor your spouse have owned a home in the past two years, you’re considered a first-time homebuyer. This comes with a special benefit – you can take out up to $10,000 of your Roth IRA earnings to help with the home purchase. The best part? You won’t owe any income taxes or early withdrawal penalties. Just remember, though, that the $10,000 limit is a total cap, and it doesn’t reset each year.

Take Out Your Contributions Anytime: One great thing about a Roth IRA is that you can withdraw the money you originally put in at any time, without facing penalties or taxes. Since you already paid income tax on that money when you earned it, you’re free to take it out whenever you need it, no matter your age or how long you’ve had the Roth IRA.

No Mandatory Withdrawals: Most retirement accounts make you start taking out a certain amount of money once you hit 73 years old (used to be 72). They call it “required minimum distributions” or RMDs. But Roth IRAs are cool because you don’t have to worry about RMDs. You can keep your money in there as long as you want, and it won’t mess with your tax situation.

Smart Way to Pass on Wealth: If you want to leave your Roth IRA to your loved ones after you’re gone, they’ll get the money without any taxes nibbling away at it. It’s a tax-efficient way to pass on your savings.

Education Savings: Some folks use a Roth IRA to save for education expenses instead of going the 529 plan route. It can be a flexible option for paying for education costs.

Roth IRA vs. traditional IRA

The Roth IRA and traditional IRA share a lot of similarities, but they also have some key differences. Both of these accounts allow you to invest in things like stocks, bonds, mutual funds, and ETFs, so you have similar investment options. Plus, in both cases, your investments can grow without being taxed along the way.

Here are the main differences between Roth and traditional IRAs:

Tax Deductions: With a traditional IRA, you might get a tax deduction for the money you put into it, but there are income limits that can affect how much you can deduct. This means contributing to a traditional IRA can lower the amount of income you have to pay taxes on right now. In contrast, when you contribute to a Roth IRA, you don’t get a tax break at that moment, but you get to enjoy tax-free withdrawals in retirement.

Retirement Withdrawals: When you take money out of a Roth IRA during retirement, it’s tax-free because you already paid taxes on the money when you earned it. But with a traditional IRA, the contributions aren’t taxed when you put them in. Instead, you’ll owe income taxes on the withdrawals you make in retirement.

Required Minimum Distributions (RMDs): With a traditional IRA, once you hit 73 years old, you have to take out a certain amount of money each year, and you’ll have to pay taxes on that money. Roth IRAs, on the other hand, don’t have these required minimum distributions, so you can leave your money in there as long as you like without being forced to take it out.