A Roth IRA can be like that bold sweater you never wear. You know it's there for you, but you're not quite sure what to do with it. And like that sweater, your Roth IRA competes with other, more familiar options -- namely, the 401(k) and traditional IRA. If you're barely contributing to your other accounts, it's tough to grasp how the Roth IRA fits in your overall savings plan.

In truth, a Roth IRA is one of the more flexible types of savings account. You can use it for retirement savings, and the tax advantages there are noteworthy. But you can also use a Roth IRA to save for other financial goals. That's because the Roth IRA has one feature that sets it apart from other tax-advantaged retirement accounts: You can withdraw your contributions at any time without penalty. To clarify, that's contributions only. Earnings in the account, which grow tax-free, are mostly off-limits until you reach the age of 59 and a half.

Cash in a Mason jar

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Roth IRA contributions: the basics

Let's start with how to put money in your Roth IRA. The Internal Revenue Service sets an annual cap on total contributions made to Roth IRAs and traditional IRAs. In 2020, that cap is $6,000 plus an additional $1,000 in catch-up contributions if you're 50 or older. Say you are under 50 and you deposit $2,000 in your traditional IRA. That means your maximum Roth IRA contribution in that same year is $4,000. Also, your Roth contributions cannot exceed the money you made from a job or from self-employment.

The IRS also imposes income limitations on your Roth IRA contributions. To be eligible for the maximum contribution, single filers must earn less than $124,000 and joint filers are limited to an income of $196,000. Partial contributions are available to single filers making between $124,000 and $139,000 and joint filers making $196,000 to $206,000. No Roth IRA contribution is allowed if income exceeds $139,000 for single filers and $206,000 for married filers.

Lastly, Roth IRA contributions are generally not tax-deductible, though some taxpayers may qualify for a partial deduction under the Saver's Credit. In 2020, the Saver's Credit is available to single filers who make less than $32,000 and married filers with income below $65,000.

Saving for retirement in a Roth IRA

If you meet the income requirements for contributions, there are two compelling reasons to use a Roth IRA for retirement savings.

  1. Tax diversification. Your withdrawals of contributions and earnings after the age of 59 and a half are tax-free, as long as you've had the account open for five years or more. Your 401(k) and traditional IRA withdrawals, on the other hand, are taxable. Tax-free withdrawals from a Roth IRA are most appealing if you expect to be in a higher tax bracket in retirement. That doesn't apply to most of us. But then, you might not know how your income will shake out in those golden years. In that case, it's not a bad idea to diversify your retirement income with a tax-free source.
  2. Estate planning. Roth IRAs are not subject to Required Minimum Distributions (RMDs). If you don't need the money for expenses, you can leave it in the account to bequeath to your loved ones.

Saving for a rainy day in a Roth IRA

Alternatively, you can use your Roth IRA to save for pre-retirement goals, since you can access your contributions at any time. This strategy makes sense if you're saving elsewhere for retirement, such as in your 401(k).

Assuming you are eligible for Roth IRA contributions, let's say you deposit $9,000 over three years. You invest those contributions in low-cost mutual funds and your balance grows to about $13,000 in six years. At that point, you decide to buy a car. You can withdraw up to $9,000 from the account without explanation and without penalties. You can't touch $4,000 in earnings unless you want to pay income taxes plus a 10% penalty.

Saving for a home down payment in a Roth IRA

There is also a way to access your Roth IRA earnings early, without paying penalties or taxes. You can withdraw up to $10,000 in earnings (plus any amount of contributions) if you use the money for a home purchase. These are the requirements:

  • It's been at least five years since your first Roth IRA contribution.
  • You and your spouse haven't owned a primary home in the past two years.
  • You use the funds within 120 days of withdrawal.

The $10,000 earnings withdrawal exception is a lifetime cap, so you can't repeat this move in the future.

Use your Roth IRA, if only just because

For an account that offers tax-free earnings growth, the Roth IRA is surprisingly flexible. If you're eligible to contribute, do so -- even if you don't have a specific goal in mind. You're not locking the money away forever, but you are putting it out of your immediate reach. That's a valuable savings strategy in its own right.

And about that bold sweater? Go ahead and wear it with jeans. You can't go wrong.