What is a Roth IRA and how does it work?

A Roth IRA is a retirement account where contributions come from your after-tax wages. The plan allows you to grow your savings tax-free and pay no tax on qualified distributions. The account does not have upfront tax benefits but it lowers your retirement tax liability due to not paying tax on withdrawals.

You can open a Roth IRA from a local bank or an online brokerage firm and similar investment companies. The contribution limits to a Roth IRA in 2024 are $7,000. If you are 50 or older, you can contribute an extra $1,000 catch-up contribution.

Here is everything you need to know about a Roth IRA.

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What is a Roth IRA?

A Roth IRA is a retirement account with unique benefits. When you have a Roth IRA, you make contributions with after-tax money, grow the account tax-free, and pay no income on your withdrawals. An alternative to a Roth IRA is a traditional IRA where contributions come from your before tax-money. Both IRAs have the same contribution limits which are $7,000 for 2024 with an extra $1,000 if you are 50 or older.

You can have both accounts at the same time but your contributions to both accounts cannot be more than the limits allowed for an IRA for any given year.

The Roth IRA does not offer upfront tax benefits but it reduces your tax liabilities during retirement. With a Roth IRA, you never have to pay tax on your savings and you can pass on the account to your descendants tax-free.

You can easily open an IRA account from banks, brokerage firms, or other investment institutions. Typically, you make contributions to a Roth IRA from your bank or send it a check by mail. Once you have money in your account, you can start buying different investments such as bonds, stocks, mutual funds, index funds, etc.

Roth IRA eligibility

While a Roth IRA is great for retirement savings, not everyone can tap into these benefits. Before you think about opening a Roth IRA, you need to meet its eligibility requirements. Your modified adjusted gross income (MAGI) and your filing status. If your income is outside acceptable limits, you will not be eligible to make Roth IRA contributions.

To contribute to your Roth IRA, you must first earn an income. Based on the income you earned, you can then, estimate your eligibility.

Let’s look at Roth IRA eligibility requirements in 2024.

If you are single or head of a household and earn an income under $146,000; you can make full contributions to a Roth IRA. The contributions you can make to the account start decreasing when your income reaches $146,000 and becomes $0 once your income hits $161,000.

On the other hand, if you are married and filing jointly; you can make a full contribution to a Roth IRA if your joint income is under $230,000. The amount you can contribute starts decreasing when your modified AGI hits $230,000 and becomes $0 at $240,000.

If you are married and filing separately, you will not be eligible to make contributions to a Roth IRA if your income is over $10,000. For income under $10,000, you can make reduced contributions to a Roth IRA.

Roth IRA contribution limits in 2024

The maximum contribution to a Roth IRA in 2024 is $7,000. If you are 50 or older you will get an extra catch-up contribution of $1,000. In other words, if you are 50 or older you can contribute up to $8,000.

If you have both Roth and traditional IRAs, the total contribution allowed to both accounts cannot exceed the limits for an IRA which are $7,000 or $8,000 if you are 50 or older.

Does a Roth IRA have RMDs?

Many retirements plan such as employer-sponsored plans and traditional IRAs come with required minimum distributions(RMDs) when you reach 73.

RMDs are the minimum withdrawals you must take from your account every year when you are 73 or older. Failure to make these RMDs may result in a 50% penalty on the amount you did not take out on time.

RMDs are not required on a Roth IRA when you turn 73 as long as you are the original account owner.

When the original account owner dies, however, beneficiaries of Roth IRA are required to start taking RMDs from the account. Furthermore, the account must be distributed within 10 years. Some exceptions to this rule apply when the beneficiary is a surviving spouse, the account was inherited by a minor, etc.

Roth IRA early withdrawal penalty

Qualified distributions on Roth IRA accounts are free of taxes and penalties. The question is: what is a qualified distribution?

By default, two main rules must be satisfied for a distribution from your Roth account to be qualified.

You need to be at least 59½
Your account must be at least 5 years old

Violating these rules will result in taxes on the earnings made on your contributions and a 10% penalty.

There are exceptions to this withdrawal rule and details have been published in the 2021 RS Publication 590-B. Besides making a withdrawal at the age of 59½, your withdrawals can also be qualified if:

You have a permanent disability
The money is taken out by a beneficiary
You are using the money to finance your first home

NOTE: You can withdraw your contributions from your Roth account at any time without taxes or penalty. This is because contributions to the account were already taxed. So, your contributions cannot be taxed twice.

Pros and cons of Roth account

Pros:

You will pass the money to your beneficiaries tax-free
You can contribute at any age
No required minimum distributions (RMDs)
You will grow your account tax-free
Qualified distributions will be tax-free and have no penalty
Comes with a wider range of investments compared to employer-sponsored plans such as 401(K)

Cons:

Low contribution limits
There are no upfront tax benefits
The 5 years rule must be obeyed before you can withdraw earnings from the account to avoid taxes and a possible 10% penalty.
Not everyone can contribute. Your income and filing status will affect your eligibility

Who can contribute to a Roth account?

There is no age limit to the Roth account. Anyone who has earned income can contribute to the account assuming that their modified AGI is within acceptable limits set by IRS.

This account also allows a working spouse to open and make contributions to his/her spousal Roth IRA. For the spousal IRA to work, however, the couple must be legally married, filing jointly, and one must be unemployed or earning a small income.

If the account holder is a minor, a custodial Roth IRA must be opened. The minor must earn an income and the account will be managed by a parent or legal guardian.

How to open a Roth IRA?

It is easy to open and manage a Roth account. Due to competition and availability on the internet, you can easily go online and open a Roth account in a matter of minutes.

Most banks, brokerage firms, and investment institutions offer Roth accounts. To have your Roth IRA up and running, you will need to use the following steps.

Check your eligibility
Choose where to open an account
Open an account by completing a form and providing the required information
Once approved, link your bank account to the Roth account and fund the account
Start investing
Automate your contributions

For details on how to open your Roth account, read the following guide.

Open Roth IRA guide: How to open a Roth IRA: Create a Roth IRA in 6 steps

Roth IRA vs. 401(K)

There is a big difference between a 401(K) plan and a Roth IRA. A 401(K) account is an employer-sponsored retirement plan that allows you to contribute a before-tax portion of your wages toward retirement. Your 401(K) contributions come from your before paycheck through payroll. For this reason, your 401(K) contributions reduce your taxable income.

This retirement plan allows you to grow your account on a tax-deferred basis and pay income tax on your distributions. When you reach 72, you must take RMDs from your 401(K) account to avoid hefty fees. As opposed to a Roth IRA, contributions to your 401(K) account are much larger.

401(K) plans are great for those who want to lower their taxable income and take advantage of employer-matching contributions.

In 2024, you can contribute up to $23,000 or $30,500 if you are 50 or older to your 401(k) plan. For the Roth IRA, you can contribute up to $7000 or $8,000 if you are 50 or older.

The Roth IRA allows you to make contributions with after-tax money. But you get to grow the account tax-free and pay no tax on qualified distributions. In addition, a Roth account does not require RMDs. However, your income and filing status will determine your eligibility. The Roth plan is good for people who have a low income now but are anticipating a higher income during retirement.

Details: Roth IRA vs 401(K): What is the difference?

Roth IRA vs. traditional IRA

Both Roth and traditional IRAs are commonly used IRAs. You can open any of these accounts from a bank, brokerage company, or another investment firm. The contribution limits you can make to both accounts are the same($7,000 or $8,000 if you are 50 or older). In addition, they all come with low fees and a wider range of investment options which include individual stocks, mutual funds, index funds, bonds, etc.

The main difference between a Roth and a traditional IRA is when tax benefits are realized. For the Roth account, you make contributions with after-tax money, grow your account tax-free, and pay no taxes or a penalty on qualified distributions.

On the other hand, contributions you make to your Traditional IRA can be tax-deductible. It all depends on your income, filing status, and other benefits you have from work. After making your contributions, you will grow your account potentially tax-free. During retirement, however, you will pay taxes on tax-deductible contributions you made to the account and earnings from those contributions.

Any contribution you made to the traditional IRA that was not tax-deductible will be withdrawn free of taxes. The traditional IRA also requires RMDs whereas the Roth IRA does not.

The traditional IRA is good for those who want to reduce their taxable incomes with no 401(K) plan from work. Or those who wish to reduce their taxable incomes without locking their money in 401(K) due to 401(K) fees and limited investment options.

For more details on Roth vs Traditional IRAs, refer to the following guide.