What is a Roth IRA?

When it comes to saving for retirement, the earlier you start, the better. An employer-sponsored retirement plan, such as a 401(k), can be an excellent starting point. But there are other options available if your employer doesn’t offer a retirement plan or you want to save more on your own. 

A Roth IRA is an individual retirement account, and unlike other accounts, a Roth IRA allows you to tap into your contributions in an emergency without paying penalties. 

However, not everyone is eligible for a Roth IRA, so it’s important to understand how these accounts work and their income limits. 

What is a Roth IRA?

There are two main types of IRAs: traditional IRAs and Roth IRAs. A Roth IRA is a type of retirement account where you make contributions with after-tax dollars. Anyone can open a Roth IRA at any age, as long as they meet income limits and the money they contribute is from a job or side hustle. 

IRAs are less popular than employer-sponsored plans like 401(k)s. Only 15% of U.S. households contributed to an IRA in 2021. But IRAs, particularly Roth IRAs, can be an effective tool to save for your retirement. 

How does a Roth IRA work? 

With a Roth IRA, you don’t get current-year tax benefits like you do with other investment accounts. That means you can’t deduct the amount of your contributions on your tax refund. 

However, your earnings grow tax-free in a Roth IRA. Once you reach the age of 59 ½, you can make withdrawals from the account without paying income taxes or penalties as long as the account has been open for at least five years. Before that age, you have to pay income taxes and a 10% penalty on the earnings if you make IRA early withdrawals. 

Because you don’t have to pay taxes on your withdrawals in retirement, a Roth IRA can be a useful choice for young people who expect to be in a higher tax bracket later on. 

5 benefits of Roth IRAs

There are five major benefits to opening a Roth IRA:

1. You can withdraw contributions at any time without penalties or taxes 

Because you’ve already paid income taxes on the money you deposit into a Roth IRA, you can withdraw contributions — but not the earnings — at any time and at any age. 

You won’t have to pay any penalties or taxes on those withdrawals, so a Roth IRA can come in handy when you have an emergency expense that pops up. 

2. You can have both a Roth IRA and a 401(k)

If you’re behind on building your retirement savings, a Roth IRA can be a valuable tool. 

Employer-sponsored accounts like 401(k) plans have annual contribution limits. Once you meet that limit, you can use a Roth IRA to save more money. This gives you a better chance of reaching your retirement goals. 

3. You don’t have to pay income taxes on withdrawals after reaching 59 ½

Once you reach age 59 ½, you can take withdrawals from your Roth IRA without paying taxes or penalties. You can use the money for any reason, even if you’re still working. This option may come in handy if you need to pay for home repairs, a child’s college education or a dream vacation. 

4. You can choose from multiple investment options

With an employer-sponsored plan, you’re limited to the investments selected by the plan administrator. Depending on your employer’s plan, you may have a limited selection of assets to choose from. 

With a Roth IRA, you have more options. You can invest in a range of securities, such as stocks, bonds, mutual funds and exchange-traded funds (ETFs). 

5. There are no mandatory withdrawals

With other retirement plans, including traditional IRAs, you must withdraw a certain amount of money from your account every year once you reach a specific age. These withdrawals, known as required minimum distributions (RMDs), force you to start withdrawing money once you reach the age of 73.

Roth IRAs work differently. They aren’t subject to RMD rules, so you can leave the money in there to grow for as long as you like. 

Roth IRA contribution limits 

The government does cap how much you contribute to a Roth IRA. As of 2023, you can contribute up to $6,500 per year. If you’re 50 or older, you can contribute up to $7,500 per year. 

You must monitor your own contributions so you don’t exceed the limit. If you deposit too much money into your account, you may incur penalties. 

The IRS taxes excess contributions at 6% per year for each year the excess amount remains in your account. To avoid the tax, you must withdraw the excess cash by the due date for your individual tax return. You’ll also need to withdraw any earnings generated from the excess contribution.  

Roth IRA income limits

Roth IRAs aren’t available to everyone; to make investments in a Roth IRA, you must meet certain income requirements. 

For 2023, you can only contribute to a Roth IRA if you earn less than $153,000 per year (or less than $228,000 if you are married and file a joint return). However, there are further restrictions for those who qualify for a Roth IRA that determine how much you can contribute per year.

Below are the contribution limits based on tax filing status:  

Roth IRA taxes and withdrawal rules

With a Roth IRA, you don’t pay taxes on your earnings or withdrawals as long as you have had the account for at least five years and are at least 59 ½ before you take a withdrawal. Otherwise, you’ll pay taxes and penalties on the earnings. 

However, there are some exceptions to the rules around taxes on Roth IRAs. You won’t have to pay the 10% early withdrawal penalty or income taxes under the following circumstances: 

• You withdraw money because you’re totally and permanently disabled.

• You withdraw $10,000 or less to purchase your first home.

• You withdraw money to pay qualified education expenses.

• You withdraw money to pay for unreimbursed medical expenses.

• You withdraw $5,000 or less after the birth or adoption of a child.

• You withdraw money to pay for repairs or expenses after a federally declared emergency or disaster.

Roth IRA vs traditional IRA

Traditional IRAs are a popular option for those who earn too much money to qualify for a Roth IRA. Although they have the same contribution limits as Roth IRAs, they differ from Roths in several ways: 

Income limit

Traditional IRAs don’t have income limits. Anyone can contribute to a traditional IRA as long as the person has earned income. 

Required minimum distributions

If you have a traditional IRA, you must begin taking withdrawals from the account — even if you don’t need the money — once you reach the age of 73. The minimum amount you must withdraw is calculated with a formula based on your life expectancy.

Tax benefits

Contributions to a traditional IRA may be tax-deductible. You may qualify for a tax deduction if neither you nor your spouse have access to an employer-sponsored retirement plan. 

Taxes on withdrawals

Unlike your withdrawals from a Roth IRA, withdrawals from a traditional IRA in retirement are subject to income taxes. 

401(k) vs Roth IRA

A 401(k) is the most commonly used retirement plan. These plans are offered through your employer, so you can only take advantage of one if your employer provides it as a benefit. A 401(k) has a higher contribution limit than a Roth IRA, and you make contributions with pretax dollars. 

Another perk of 401(k) plans is that your employer may match your contributions, up to a percentage of your salary. For example, your employer may match 100% of your contributions, up to a maximum of 6% of your salary. If you earned $40,000 per year, that means your employer would contribute up to $2,400 to your retirement plan per year. 

However, 401(k) plans have some limitations. You cannot use the money from your 401(k) before your retirement; if you take money out, you have to pay income taxes and penalties.

Rollover 401(k) to Roth IRA

Because your 401(k) plan is tied to your employer, you may have to make changes when you leave your job. When you change jobs, you have the option of cashing out the account (which can result in a massive tax bill), transferring it to a plan with your new employer or rolling it over to an IRA. Roth IRA conversions allow you to move your 401(k) into a Roth account and continue to save for retirement.

How to open a Roth IRA

To open a Roth IRA, follow these steps: 

Step 1: Double-check your eligibility

Before opening a Roth IRA, check that your income falls within the income restrictions for Roth IRA contributions. 

Step 2: Choose a broker

You can open a Roth IRA online through an online brokerage firm, investment advisor, robo-advisor or bank. When comparing your options, consider factors like trading fees, account minimums and investment options.

Step 3: Fill out forms

Most brokers allow you to open an account online, but you have to complete certain forms and provide proof of identification, such as a copy of your driver’s license. You will also need to provide your Social Security number and bank information. 

Step 4: Pick your investments

If you’re using an advisor or robo-advisor, they will pick your investments for you. Otherwise, you’ll have to pick your investments on your own. Depending on the broker, you can choose from a variety of stocks, bonds, mutual funds, ETFs and other securities. 

Step 5: Stick with it

As with any investment account, your Roth IRA may fluctuate in value over time. That’s normal; stick with it! As long as you have a diversified portfolio, you can weather those changes and take advantage of market growth over time.