When it comes to retirement investments, one plan stands out above the rest. It allows you to build wealth and increase your retirement savings in a simple, easy-to-manage account that comes with tax advantages.
It’s a Roth IRA and it basically means tax-free growth! The Roth IRA is an individual retirement account (IRA) that allows qualified withdrawals on a tax-free basis provided certain conditions are met. The plan was established in 1997 and named after former Delaware Senator William Roth.
In the simplest terms, the Roth IRA is a tax-advantaged savings account for qualifying individuals to manage their retirement savings. If you contribute to a Roth IRA, you save money for retirement and get tax breaks for doing so.
The Roth IRA, one of the four most popular IRA account types, is one of the least restrictive plans. Note that IRAs in general are only available to US citizens.
How does a Roth IRA work?
Similarly to other IRAs, a Roth IRA is available to individual taxpayers of any age as long as they have earned income that meets Internal Revenue Service (IRS) rules. Funds paid into a Roth IRA are called contributions and they can come from a number of sources, including regular contributions, spousal IRA contributions, rollover contributions, transfers and conversions of other types of of IRA accounts. Bear in mind that you cannot contribute income from investments, inheritance, Social Security benefits, or child support to a Roth IRA.
Regular contributions must be made in cash (which includes checks), securities or assets are not permitted. However, once the funds are contributed, there are numerous investment options, including mutual funds, stocks, bonds, ETFs, and money market funds.
Roth IRAs are funded with after-tax dollars, meaning you’re taxed on the funds when you put them in. This is a smart long-term strategy if you think that your taxes will be higher in retirement than they are now. Even though contributions to a Roth IRA are not tax-deductible, once you start withdrawing funds, the money is tax-free.
One of the key prerequisites of the Roth IRA is that it comes with an income cap. This means that you can’t open a Roth IRA if your paycheck exceeds the cap. The limit is determined on the basis of the account owner’s modified adjusted gross income (MAGI) and filing status. In 2021, the total contribution cannot exceed:
- $6,000 ($7,000 if you're 50 or older), or
- your taxable compensation for the year, if your compensation is less than the above dollar limit.
The IRS changes the amount you can contribute periodically. The following table contains the annual contribution limits depending on your MAGI and filing status.
|Filing status||2020 MAGI||Contribution Limit|
|Single, head of household or married filing separately (you did not live with your spouse at any time during the year)||Less than $124,000||$6,000 ($7,000 if 50 or older)|
|$124,000 up to $139,000||Reduced contribution*|
|More than $139,000||No contribution|
|Married filing jointly or qualifying widow(er)||Less than $196,000||$6,000 ($7,000 if 50 or older)|
|$196,000 up to $206,000||Reduced contribution*|
|More than $206,000||No contribution|
|Married filing separately and you lived with your spouse at any time during the year||Less than $10,000||Reduced contribution*|
|More than $10,000||No contribution|
*Visit this IRS page for guidance on how to calculate the reduction.
How to withdraw funds from a Roth IRA?
Roth IRAs are governed by relatively lax withdrawal rules in comparison with other types of IRA accounts. You can fund and maintain the Roth IRA for as long as you live and there are no required minimum distributions (RMDs) during their lifetime, as there is with 401(k)s and traditional IRAs.
Once Roth IRA account holders turn 59½ and provided they have had the Roth IRA for at least five years, they can make so-called qualified distributions from the account, if they meet qualified distribution criteria set by the IRS. These distributions are tax free since the funds contributed to the account are after-tax money.
You can take out the funds you contributed to a Roth IRA but not the investment earnings at any time without paying a penalty. If you converted money from a traditional IRA into a Roth IRA, you can't take it out penalty-free until at least five years after the conversion.