Roth IRA Explained - What, Who, When, Where, Why, & How
The Roth IRA explained. This post is a guide for the U.S. tax-exempt individual retirement account. In it we'll explore what a Roth IRA is, who they're for, when to contribute, and where, why, and how to open one.
What Is a Roth IRA?
A Roth IRA is simply a U.S. retirement savings vehicle by which investors contribute after-tax money, that money grows tax-free, and the withdrawals later in retirement are tax-free.
The Roth IRA was established in 1997 by the Taxpayer Relief Act. IRA explicitly stands for individual retirement account. As the name suggests, this is an account designed to help individuals save for retirement.
Who Can Contribute To a Roth IRA?
Whereas an account like a 401k is tied to your employer, anyone with earned income can open a Roth IRA on their own, provided that income is below the eligibility limit. We'll cover income limits later.
How Does a Roth IRA Work?
The main function of the Roth IRA is that contributions are made with post-tax dollars and then those contributions are allowed to grow tax-free and later be withdrawn in retirement tax-free. In other words, contributions to a Roth IRA are taxed on the front end and not on the back end.
Those contributions must be made in cash and cannot be in the form of securities or property. The IRS limits the amount of annual contributions that can be made to a Roth IRA. We'll go over these contribution limits shortly.
Roth IRAs do not have required minimum distributions, or RMDs, like 401k's and Traditional IRAs do. You can withdraw your contributions penalty-free anytime and you can withdraw earnings anytime after 59.5. This means the Roth IRA has arguably the greatest flexibility of retirement accounts available to Americans.
Since the Roth IRA does not have RMDs, this also makes it a great wealth transfer vehicle because your heirs can withdraw tax-free.
There are also special cases that allow for the early withdrawal of earnings without penalty, including:
First time home purchase; you can withdraw up to $10,000.
Higher education expenses
Medical expenses
Death
Disability
Substantially equal periodic payments
Consult your tax professional if any of those apply to you.
Also note that you can open a Roth IRA in addition to an employer-sponsored plan (ESP) like a 401k.
Roth IRA Investments
You have a wide variety of things you can invest in inside a Roth IRA, including mutual funds, ETFs (Exchange Traded Funds), stocks, bonds, money market funds, certificates of deposit (CDs), cryptocurrency, and more. You can even hold investment real estate in a Roth IRA.
When To Contribute To a Roth IRA
There is no age requirement to open a Roth IRA, provided that person has earned income to cover the contributions. A Roth IRA can be created anytime, but contributions for the current year must be made by the owner's tax deadline, which is typically April 15 of the following year.
For those contributing every year to save for retirement, remember that the evidence indicates that on average it is advantageous to get money in the market as soon as possible, which is why savvy investors try to max out their annual contribution as soon as possible each year around January 1.
Note that contributions must come from earned income, which could include wages, salaries, commissions, bonuses, and business income (if self-employed). The following sources are not eligible:
rental income
interest income
pension income
annuity income
stock dividends
capital gains
Roth IRA Income and Contribution Limits
Now we'll cover the income and contribution limits for a Roth IRA. Note that these typically change every year so the numbers here may be outdated depending on when you're seeing this.
Eligibility to contribute to a Roth IRA is determined by your Modified Adjusted Gross Income, or MAGI for short.
At this time in 2023, the annual contribution limit for individuals for a Roth IRA is $6,500 if below age 50 and $7,500 if age 50 or older, up from $6,000 and $7,000 respectively for 2022.
A working spouse can also make contributions for a non-working (or low-earning) spouse as long as the sum of both spouses’ contributions does not exceed the sum of their incomes.
The current annual income limits to be eligible to contribute to a Roth IRA in 2023 are $153,000 if single and $228,000 if married filing jointly. Phase-outs for reduced allowed contributions begin at $138,000 if single and $218,000 if married filing jointly.
If your income is above those limits, you can use a technique called a "backdoor Roth IRA" where you make a nondeductible contribution to a Traditional IRA and then convert it to a Roth IRA, thereby allowing very high earners to legally get around the income limits.
Also note that your Roth IRA contribution cannot exceed the income you earned for that year.
How To Open a Roth IRA
Most brokerages like Schwab, Fidelity, Vanguard, etc. offer both Roth IRAs. Exian clients have access to a Roth IRA. Contact us today to open one.
Roth IRA FAQ's
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There is no "best" Roth IRA. The account structure and functions are universal; a Roth IRA at Vanguard is the same as a Roth IRA at Fidelity.
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The Roth IRA was established in 1997 by the Taxpayer Relief Act.
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No. Roth IRA contributions are made with post-tax money, so they do not reduce taxable income, but withdrawals are tax-free.
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Technically, yes. Roth IRA contributions can be withdrawn tax- and penalty-free anytime. Earnings can be withdrawn without penalty in special cases, one of which is higher education expenses. Consult your tax professional on your specific situation.
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No, Roth IRAs do not have RMDs, or required minimum distributions.