Understanding Roth IRAs

Updated: Oct. 6, 2020, 2:40 p.m.

What is a Roth IRA?

A Roth IRA is an individual retirement account that allows investments to grow in value tax-free and for withdrawals to be made without being taxed under a number of conditions. This is different from most other retirement accounts, where distributions are considered taxable income.

A Roth IRA isn't a specific kind of investment; it's a kind of account you can use for the tax benefits. You still choose the investments, including stocks, bonds, certificates of deposit, mutual funds, and ETFs. Whether you profit or lose money is based on the investments you choose. Eligibility for a Roth IRA depends on your income, with limits to how much you can contribute.

Benefits of a Roth IRA

Here are the biggest benefits:

  • Your investments grow tax-free.
  • Qualified distributions are tax-free.
  • You can take out $10,000 as a first-time homebuyer tax-free.
  • You can withdraw your original contributions tax-free at any time.
  • There are no required minimum distributions (RMDs start at 70 1/2 for other retirement accounts).
  • You can make Roth contributions at any age (contributions are not allowed past 70 1/2 in other IRAs).
  • Roth balances left to heirs at your death remain tax-free.

The tax benefits can be enormous. For instance, if you are retired and intend to make a large purchase one year, taking a tax-free distribution from a Roth that year could result in a much smaller tax bill than taking a distribution from a traditional IRA or 401(k) that pushes you into a higher tax bracket.

Roth IRA rules

The benefits of the Roth IRA come with a few limitations. The first is the contribution limit of $6,000 for 2020 for individuals under age 50. Those 50 or older can make a total of $7,000 in contributions in 2020 -- $1,000 in "catch-up" contributions on top of the $6,000 contribution limit.

The amount you can contribute is also limited by how much you earn. The table below breaks down how your earnings and tax filing status affect how much -- if anything -- you can contribute to a Roth IRA in 2020:

Filing Status Contributions Are Reduced If Income Is Above This Amount No Contribution Allowed If Income Exceeds This Amount
Single, head of household, or married filing separately IF you didn't live with your spouse during the year $124,000 $139,000
Married filing jointly or qualifying widow or widower $196,000 $206,000
Married filing separately IF you lived with your spouse at any point during the year $0 $10,000

Data source: Internal Revenue Service.

A series of rules governs what is considered a "qualified distribution," meaning one you can take tax-free. From the Internal Revenue Service (with minor edits for brevity and clarity):

  • The payment or distribution must be made after the five-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and one of the following must be true:
  • The payment or distribution is:
    • Made on or after the date you reach age 59 1/2,
    • Made because you are disabled,
    • Made to a beneficiary or to your estate after your death, or
    • One that meets the requirements for a first-time homebuyer.

If you take a distribution that doesn't meet these requirements or isn't a withdrawal of original contributions, it could be subject to taxation as part of your earnings that year, as well as an additional 10% penalty.

Another important rule for Roth IRAs: You can't deduct your contributions from your taxable income as you can with 401(k)s and similar plans or traditional IRAs.

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Roth IRA vs. traditional IRA

The Roth IRA and the traditional IRA have a few things in common. First, you can generally invest in the same assets, including stocks, bonds, mutual funds, and whatever other assets your brokerage offers. Additionally, your investments will grow tax-free so long as you leave them inside the account.

Now the differences. With a traditional IRA, you may be able to deduct your contributions from your taxable income the year you make them, though there are income limits that could affect how much you are allowed to deduct. This saves you on taxes today.

With a Roth, your contributions are not deductible from your income. However, things are reversed on the other end. When you take distributions in retirement, it's the Roth that is tax-free, while distributions from a traditional IRA are added to your taxable income and taxed at the tax bracket they push your total earnings into.

Other big differences include required minimum distributions. With a traditional IRA, once you turn 70 1/2, you are required to take a distribution every year, whether you need the income or not, and since those distributions are taxed, they will increase your taxable income. With a Roth, you are never required to take a distribution.

Which is better depends on a number of factors, including your earnings and marginal tax rate. If you earn too much, you may not even be able to contribute to a Roth. Depending on your tax situation, lowering your taxable income with a traditional IRA today might be the right move. It's something that you should reevaluate every year.

How to open a Roth IRA

Opening a Roth IRA is as simple as setting up an account with your favorite brokerage. Don't have a brokerage account yet? Start here to review the top online brokerages to find the right one for you.

Setting up a Roth IRA takes only a few minutes, and you should be able to start investing for retirement within a few days of making your contribution.