What is a Roth IRA and Everything You Need to Know About It

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Today marks the beginning of the Roth IRA Movement. There is an astounding lack of knowledge about Roth IRAs in the public; this is especially true of the younger generations that have the most to benefit from the long term tax benefits of saving in a Roth IRA.

What is a Roth IRA?

IRA stands for Individual Retirement Account or Individual Retirement Agreement. It is the name given to a specific type of retirement account by the government. There are two types of IRAs: a Traditional IRA and a Roth IRA.

  • A traditional IRA is a pre-tax retirement account; saving money with this account lowers your gross income (and thus your taxes) today and you pay taxes when you withdraw funds in retirement.
  • A Roth IRA is a post-tax retirement account; saving money with this account means you pay taxes today (you invest after-tax dollars) but you never pay taxes on the money again no matter how large your nest egg grows.

How Much Money Can I Save Each Year?

The amount of money you can save into a Roth IRA is referred to as the contribution limit. Unlike a 401k that has a much higher contribution limit, all IRAs (Roth and Traditional) limit your contributions to $5,500 per year.

Remember, this is an individual retirement account. If you are married, you and your spouse can each save $5,000 per year for a total of $10,000.

Catch Up Contributions

If you are over the age of 50 you are also allowed to contribute an additional $1,000 every year to help “catch up” your retirement accounts as you near retirement age. For a married couple that are both over age 50, you could contribute a total of $12,000 per year toward retirement.

Check out this article for the current year contribution limits for Roth and Traditional IRAs.

What Investments Can I Hold in a Roth IRA?

Roth IRAs are very versatile accounts that let you hold a wide variety of investments. Which specific investments you can hold is dependent upon the company that holds the investments for you. If you go with an online brokerage firm you will be able to hold your typical stock, bond, ETF, and mutual fund investments.

If you choose to go with a self-directed Roth IRA you may be able to invest in a wider variety of investments. These exotic investments include rental property, physical precious metals, and annuities. However, since you won’t be going with traditional investments and a traditional brokerage firm, much research is required before moving forward.

Check out this article for information about how to open a Roth IRA account.

How Do I Qualify to Use a Roth IRA?

Qualifying to contribute in a Roth IRA is relatively easy.

Income Limit

One of the first qualifications that can disqualify you from investing in a Roth IRA is the amount of income you earn during a given year. The income limit for Roth IRAs is dependent upon your tax filing status and your modified adjusted gross income:

  • For single filers, you can contribute in full if you earn less than $110,000 per year. Your ability to contribute phases out up to $125,000 per year. After that you will not be able to use a Roth IRA for that tax year.
  • For those that file married joint tax returns, you can each contribute in full if you earn less than $173,000 total. Your ability to contribute phases out up to $183,000. After that you will not be able to use a Roth IRA for that tax year.
  • For those that file married separate returns, your ability to contribute is extremely limited. Essentially you are only allowed a partial contribution if you earn $10,000 or less during the year.

Age Rule

Unlike some other accounts, there is no minimum age you must reach to be able to contribute to a Roth IRA.

Earned Income Requirement

You can contribute to a Roth IRA no matter how old you are. However, that doesn’t mean your elementary age child can open a Roth IRA while you fund the account. To contribute to a Roth IRA you must have earned income equal or above the amount you contribute. If you only earn $3,000 in a given year, you cannot contribute more than that amount to the Roth IRA despite the contribution limit being $5,000.

When Can I Withdraw Money from a Roth IRA?

Most retirement accounts require you to keep the money invested inside the account until age 59 and 1/2 when you may begin taking distributions. Any withdrawals before that age results in taxes and penalties that eat away at your nest egg. This is not the case with the Roth IRA thanks to the investments being made of after-tax income.

Withdrawing Contributions

You may fully withdraw all contributions made to your Roth IRA at any time without any taxes or early withdrawal penalties. These withdrawals can be made at any age; you do not need to be age 59 and 1/2.

Withdrawing Earnings

However, to be able to withdraw the earnings from your Roth IRA without tax or penalty, you must be age 59 and 1/2. For example, if you contributed $100,000 to your Roth IRA over the years and that investment grew to $350,000, you have $100,000 in contributions and $250,000 in earnings. You could withdraw the initial contributions of $100,000 at any time. You must wait until age 59 and 1/2 to touch the remaining $250,000.

Early Withdrawal Penalty

If you are in a financial bind and need to withdraw some of your Roth IRA’s earnings, you will be hit with a 10% early withdrawal penalty that must be paid to the IRS.

Required Minimum Distributions

One of the best features of a Roth IRA is you are never required to withdraw money from the account. You can die and pass on the full account to your heirs without any withdrawals being forced. A Traditional IRA is treated differently: you must begin taking distributions at age 70 and 1/2.

The key difference between the two accounts is a Roth IRA has already been taxed — you paid taxes on the money you used to invest in the account originally. A Traditional IRA has not paid taxes (you pay upon withdrawal) and the government forces you to eventually begin taking distributions so the income can be taxed.

Check out this article for a more in depth discussion about the best strategy to withdraw money from retirement plans.

Roth IRA Taxes

A Roth IRA is funded with money that has already been taxed as part of your earned income. Once that money is taxed and invested into a Roth IRA it will never be taxed again from an income tax perspective. There are no additional taxes taken out or owed when you withdraw funds from your Roth IRA.

Are Roth IRAs Better Than Traditional IRAs?

Whether or not a Roth IRA is the better investment vehicle for your retirement is dependent on a few factors: if you qualify for an account and what you believe will happen to personal income taxes in the future. If you believe the tax bracket you are in now will be lower than what your tax bracket in the future will be, then a Roth IRA is a wise move. Otherwise, a Traditional IRA is probably a better fit for your nest egg.

Check out this article for a deeper discussion about how to choose the right IRA for your situation.

Looking for other Roth IRA Movement articles? Check out #RothIRAMovement on Twitter.

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12 years ago

Thanks for being part of the #RothIRAMovement!

Harry Lamory
Harry Lamory
12 years ago

I can understand the lack of knowledge, this is a fairly complicated system, Thanks for this great explanation though, the more people who read this the more this movement will take off.

12 years ago

I finally got a Roth IRA a few yrs ago. For me it was….would I rather pay 2010 taxes or 2040 taxes? May not be the most sophisticated criteria but I’m a simple girl.

12 years ago

I have a Roth IRA and a 4N1FUND. I’m pretty happy with them both. As a freelancer, there are no 401k options that I’m aware of, but that’s fine. Thanks for this summary! I will def link to it from my blog, very helpful.

Ariel Monde
11 years ago

I contribute to a Roth IRA (spousal contribution from my earned income, as I don’t have earned income for the year). According to the tax software I use (H&R freefile), I can take the Saver’s Credit. Does that sound correct to you all? It would be great to claim the credit, but I want to make sure it’s ok. I don’t know what the logic behind the rule that full-time students can’t take the credit is. According to Roth regulations, students can make contributions as long as the money comes from earned income.

Pinyo Bhulipongsanon
11 years ago

According to what I read and understand, I think you could take the credit as long as you meet the filing and income guidelines. However, if you’re a full-time student, you might be out of luck. I don’t know the logic either, but may be it has something to do with full-time students are already eligible for other tax credits.

What is a Roth IRA and Everything You Need to Know About It

by Kevin Mulligan time to read: 5 min
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