A Roth IRA is an individual retirement account (IRA) in which money grows tax-free and withdrawals during retirement are tax-free.
People at least 59½ years old and who hold their accounts for at least five years can take distributions, including earnings, without paying federal taxes.
The two main characteristics of an IRA over a traditional retirement account:
- The dollars you invest in the Roth IRA are “after-tax dollars” meaning you already paid tax on the contribution going into your account
- Since you have already paid taxes on the contributions, you will not receive a tax deduction for contributing to this account.
How it Works
Here are the basics to help you understand Roth IRAs.
- You invest your money in the account. A Roth IRA is an individual retirement account that holds your investments, rather than an investment itself. Investments that you make in your Roth IRA can increase or decrease in value. Your overall return will depend on how you invest.
- You open a Roth IRA at a brokerage or bank. Next, you select your choice of investment, you have options such as mutual funds, stocks, bonds, exchange-traded funds (ETFs), or bank savings products.
- You can add money to it over time. You have the option to contribute one lump sum or make smaller contributions over the course of the year, as long as your total yearly contributions do not exceed $6,000 ($7,000 if you’re 50 or older) or your taxable compensation, whichever is smaller. (That’s the maximum annual contribution in 2020.) Additionally, you can add money to your Roth by rolling over another retirement account.
- Your contributions aren’t tax-deductible. Unlike traditional IRAs, you do not get a tax deduction for contributing to a Roth IRA.
- Withdrawals are TAX-FREE. In general, you can withdraw your contributions without owing penalties or taxes (you’ve already paid taxes on the money you put in).
Here are the basic qualifications for the Roth IRA
You must have an earned income.
To contribute to a Roth or traditional IRA, you must have income from work (the IRS term is “taxable compensation”). The maximum annual contribution is your income from work or $6,000 ($7,000 if you’re age 50 or older), whichever is less.
You must be under the income limit.
The amount you can contribute to a Roth IRA begins to shrink at certain thresholds based on adjusted gross income and keeps getting smaller as income rises until your ability to contribute is eliminated completely. (The backdoor Roth strategy offers a workaround — we’ll let you know if this applies.)
Is it worth it?
It depends. What makes the Roth IRA so special is that all of your contributions to the account grow tax-free. This means that when it comes time for retirement, your investment account, all growth included, can be withdrawn without being required to pay taxes, such as when withdrawing from a traditional IRA.
If you match the qualifications, a Roth IRA could be an amazing tool to further secure your retirement.
Interested? Talk to an expert or check out this year’s maximum contribution limits & associated income levels from the IRS.