Roth IRA: What It Is, How It Works & How To Start One (2024)

What is a Roth IRA?

A Roth IRA is funded with after-tax dollars, which means you pay income taxes on the money before contributing it. However, the benefit is that a Roth provides tax-free income when you retire. Additionally, the money grows tax-free, which means you don't pay capital gains taxes on the money it generates over time.

In comparison, contributions to a traditional IRA are tax deductible because you pay income taxes on the money when you take it out in retirement. You don't pay capital gains taxes on this type of IRA either.

When trying to choose between a Roth and traditional IRA, it's important to think about when you will pay more in taxes. If you think your taxes will be higher while you are working, it's best to get a traditional IRA, but if you think your taxes will be higher when you retire, you should get a Roth.

However, there are income limits on a Roth IRA, so if you make too much money, you won't be able to contribute to one. There are also contribution limits on a Roth IRA. These accounts can be funded through regular contributions, contributions from your spouse, transfers, and IRA rollovers and conversions.

Tip: A Roth IRA differs from a traditional IRA in that the money is taxable upon contribution but not taxable when it is withdrawn, as long as certain requirements are met.

How Do Roth IRAs Work?

After you establish a Roth IRA, you can contribute money every year, paying taxes on it when you contribute the funds. There are no required minimum distributions at any age, unlike some other retirement accounts. As long as you are 59 and a half and have held your account for at least five years, you can take distributions without paying taxes on the money. If you withdraw from the Roth early, you may pay a 10% penalty and taxes on the withdrawal. Taxes only apply to money your contributions earned after being put in and not to the money you contributed.

After you contribute money to a Roth, the firm that's managing it invests that money in a wide variety of assets, including stocks, bonds, mutual funds, real estate or CDs. The best investments are those that take advantage of how the Roth IRA works, which are those that would otherwise cause a sizable tax bill. Good investments for a Roth include assets with large growth potential, sizable dividends, and high turnover levels.

Great Roth IRA investments include:

• Mutual funds
• Dividend stocks
• Individual stocks and bonds

Roth IRA Contribution Limits

There are also some Roth IRA contribution limits. The most one can contribute in 2022 is $6,000, although individuals age 50 or older can contribute up to $7,000. These numbers can change each year. It's important to check them before making any contributions to a Roth.

Additionally, if one files taxes jointly with a spouse who doesn't work, individuals can also make contributions for them to a spousal IRA, up to the same limits outlined above.

Roth IRA Income Limits

There are some Roth IRA income limits, so keep these in mind when thinking about opening one. These numbers can change from year to year—check the amounts for every tax year set by the IRS. The numbers given are for 2022.

Single or Married Filing Separately (not living with spouse)

For those who identify as single, head of household, or married filing separately and did not live with your spouse, the Roth IRA income limit is:

• $129,000 can contribute the maximum amount ($6,000)
• $144,000 can contribute a reduced amount

Married Filing Jointly

If you are married and file your taxes jointly, you must have a modified adjusted gross income of less than $204,000 to contribute the maximum amount every year.

• Less than $204,000: contribute the maximum amount ($6,000)
• Between $204,000 and $214,000: can contribute a reduced amount.
• Greater than $214,000: can not contribute

Married Filing Separately (living with spouse)

If you are married and file your taxes separately but live with your spouse, your income must be less than or equal to $10,000 to contribute a reduced amount.

Backdoor Roth

You could also take the backdoor route if you want to open a Roth but make too much money. This method involves putting the money in a traditional IRA and then converting it to a Roth.

However, there are some tax consequences with doing this, and the money can't be moved back to a traditional IRA. You will have to pay taxes on the money you transfer from the traditional IRA to the Roth during the tax year in which you do it, but you won't owe taxes on the money when you withdraw it.

Tip: You must make no more than a certain amount of money to open or contribute to a Roth IRA, and you can't contribute more than a certain amount every year.

Withdrawing from a Roth IRA

Roth IRA withdrawals are not complex. Some retirement accounts require you to take at least a certain amount of money out of them every year when you hit a certain age, but that isn't true of Roth IRAs. You can tap the money you contributed at any time. However, you have to wait until age 59 and a half and five years after opening the account to start using the money earned on your investments unless you are willing to pay taxes and a 10% penalty.

Qualified Distributions

Qualified distributions are those made without taxes or penalties due. A distribution is qualified if your account has been:

• Open at least five years
• The withdrawal is made on or after the day you turn 59 and a half

Examples of exceptions to the rule that qualify as qualified distributions include withdrawals taken:

• Due to a permanent disability
• By beneficiaries or your estate after your death
• To buy, build or rebuild your home, up to $10,000
• To cover premiums for medical insurance after losing your job or if the distribution results from an IRS levy
• For qualified reservist distributions
• To cover qualified disaster recovery
• To pay for qualified education expenses
• To cover the cost of childbirth or adoption, up to $5,000

Non-qualified Distributions

Non-qualified distributions are those that incur taxes at your usual income tax rate and a 10% penalty. The taxes apply only to earnings on the money you contributed, not to your contributions. However, there are some exceptions to this rule. For example, you can take distributions without taxes or a penalty if you have unreimbursed medical expenses that exceed 10% of your adjusted gross income.

Advantages and Disadvantages of a Roth IRA

Pros:

• Tax savings: Perfect for those who expect to pay more taxes in retirement than while they're working.
• Pairs well with a 401k: You can contribute to both a Roth and a 401k, and you can choose when and how much to contribute, up to a certain limit per year.
• No age limit to open an account
• Extended contribution deadline: You have up to your tax filing deadline to contribute each year for the year before
• Do not require minimum distributions when you reach a certain age.
• You can withdraw the money you contributed at any time, although you can't tap into the money your investment earns until later in life unless you pay a 10% penalty and income taxes on the earnings.

Cons:

• Can't take a loan from a Roth the way you can with a 401k
• Withdrawal penalty: there's a 10% penalty on withdrawals of your investment earnings before the age of 59 and a half, although there are a few exceptions.

How to Open a Roth IRA in 5 Easy Steps

To open a Roth, you must visit a firm that has IRS approval to offer them. However, before you start working with any firm, you should think about whether you're a do-it-yourself investor or someone who wants everything to be done for them by the firm.

Step 1: Decide On a Firm or Brokerage For Your Account

If you want to choose your investments yourself, you should probably start an account with a brokerage. However, if you aren't very savvy when it comes to investing, you should probably choose a robo advisor or a human financial advisor to manage your Roth. A robo advisor is generally less expensive than a human financial advisor. It builds a portfolio based on the questions you answer about your risk tolerance, age, and other factors.

Every firm that offers a Roth IRA is different, with each one having its own fee structure and investment options. Some firms offer a wide array of investment options, while others are more restrictive. If you plan to make a lot of trades, you should look for one that has low fees on trades. Other firms charge a fee if you leave your account inactive for too long.

If you plan to open a Roth with your bank, you should find out if it comes with any other banking products. Always ask about requirements before choosing a firm.

Step 2: Fill Out the Necessary Forms and Paperwork

Once you've selected a firm and are ready to open a Roth, you must fill out a form with the firm you have selected, either online yourself or with the help of a customer service representative.

Collect the following in order to fill out the forms in full:

• Driver's license or photo ID,
• Social Security Number
• Bank account number and routing number
• Name and address of your employer
• Name, address and Social Security Number of the person who will inherit the account on hand

It's important to name a beneficiary because the person will receive the account directly after your death instead of having to go through the probate court.

Step 3: Move Money Into the Roth IRA Account

Now that your account is open, you need to transfer funds into the account. There are often minimum account balances required with some accounts. Some firms require more money than others. Be sure to follow those requirements when depositing funds.

You can fund your new account using the bank account you connected when filling out the above form, or from other accounts with taxed money. Follow the instructions provided by your firm's website or representative.

Step 4: Choose What to Invest Your Money Into

The investment options provided will vary by firm. Follow your firm's instructions when selecting your investments.

Bottom Line

Roth IRAs are good for people who expect to have a lower income tax rate while working than in retirement. You contribute money after paying income tax on it, and the money grows tax-free, as long as you don't withdraw the earnings before age 59 and a half or before the account has been open for at least five years.