10 Roth IRA Basics You Need to Know

The Roth IRA is a powerful tool in your retirement savings arsenal, but it can be easily misunderstood. This tax-advantaged account works differently than your standard 401(k) or traditional IRA, and that has pros and cons. Fortunately, it's easy to maximize the pros and minimize the cons when you understand a few Roth IRA basics.

Here are the 10 characteristics of a Roth IRA you need to know as you work toward financial independence.

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You get tax deductions for 401(k) contributions and, usually, for traditional IRA contributions, too. You do not get tax deductions for contributions you make to your Roth IRA.

At first glance, that may feel like a disadvantage for the Roth. After all, it's cheaper to save with pre-tax than after-tax money. The after-tax nature of Roth contributions, however, creates other tax and withdrawal advantages that you don't get with a 401(k) or traditional IRA.

Those advantages, explained in later slides, make the Roth IRA more flexible than any other tax-advantaged retirement account. While a 401(k) and traditional IRA are positioned for retirement savings only, the Roth could support any long-term savings effort. It's also a good choice for anyone who wants to retire earlier than age 60.

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Since you contribute to a Roth IRA with after-tax dollars, your qualified withdrawals in retirement are tax-free. That is not the case with a standard 401(k) or a traditional IRA. In those accounts, your retirement withdrawals are taxable as ordinary income.

Technically, the Roth IRA benefits you most when you are in a higher tax bracket in retirement than you were in your working years. In this scenario, you'd pay a lower tax rate on your contributions now. In return, you'd sidestep the higher tax rate in retirement.

If your retirement income is lower than your working income, the opposite is true: You'd pay a higher tax rate today on Roth contributions instead of a lower tax rate in retirement. While this second scenario is less appealing mathematically, there's still a case for contributing to a Roth. For one, you may know where you'll end up in retirement. And two, prepaying some retirement income taxes today provides valuable peace of mind.

Withdrawal flexibility is another compelling advantage associated with the after-tax contributions you make to a Roth. Because you've already paid taxes on those Roth contributions, the IRS doesn't restrict you from accessing those dollars. Specifically, you can withdraw your contributions from a Roth IRA at any time, without taxes or penalties. In a 401(k) or traditional IRA, you normally must wait until age 59 and a half to take withdrawals without penalty. Since the Roth doesn't have that rule, you could technically use this account type for any type of long-term savings, retirement or otherwise.

There is an important caveat here. You can withdraw your contributions, but not the earnings on those contributions. Fortunately, when you take money from your Roth IRA, the IRS assumes you're pulling the contributions first. If you withdraw all your contributions, then any additional withdrawals prior to age 59 and a half may be subject to taxes and penalties.

You do not pay taxes every year on your investment earnings in a Roth IRA. That perk expedites your savings growth. Say you are paying 25% combined in state and federal income taxes. If the investments in your Roth grow at 8% this year, you get to keep the full 8%. Hold those same investments in a taxable account and your return net of taxes is only 6%.

Plus, if you comply with the IRS rules on withdrawing your Roth earnings, you won't ever pay taxes on those earnings. That's quite different from a traditional IRA or 401(k). In those accounts, the earnings are tax-deferred. You don't incur taxes from year to year, but you will pay the taxes on any amounts you withdraw.

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You must follow two rules to avoid taxes and penalties when withdrawing earnings from your Roth. First, you must be 59 and a half years old. The second is called the five-year rule: Five years must have passed since your first Roth contribution. If you don't meet either requirement, you could pay income taxes and a 10% penalty on any earnings you withdraw. You may owe the taxes only if you withdraw earnings after you reach 59 and a half, but before you've satisfied the five-year holding period.

The five-year rule also applies to funds converted from a traditional IRA to a Roth IRA. You must wait five years to tap those converted balances, no matter how old you are. If you jump the gun, you'll probably owe a 10% penalty on the withdrawn amount.

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Like a 401(k), IRAs are subject to annual contribution limits. These limits can change from year to year, but the cap is $6,000 in 2021. If you are 50 or older, you're also allowed an additional $1,000 in catch-up contributions.

The tricky thing is, these limits apply to your cumulative IRA contributions. You cannot contribute $6,000 to a Roth IRA and $6,000 to a traditional IRA in the same year, for example. Nor could you send $6,000 to one Roth IRA and $6,000 to a different Roth IRA in the same year. You must split up the $6,000 or $7,000 across all your IRAs. If you deposit $3,500 to a Roth and you're 49 years old, you can't deposit more than $2,500 to any other IRA, traditional or Roth.

The IRS imposes income caps on Roth IRA contributions. As a single filer, you can contribute up to the annual limit if your modified adjusted gross income is less than $124,000. If you are married and file jointly, the income cap is $196,000.

The IRS also specifies income ranges that allow you to make a reduced contribution, something less than the annual limit. Your tax professional can help you understand how much less, since it depends on your exact income. The income range for single filers to make a reduced contribution is between $124,000 and $139,000. If you're married and filing jointly, the range is $196,000 to $206,000.

If you are single and earn $139,000 or more, you cannot contribute anything to a Roth IRA. The same is true if you are married filing jointly and your modified adjusted gross income is $206,000 or more.

ALSO READ: Beat Capital Gains Taxes With the Roth IRA

You can leave funds in a Roth IRA for as long as you want. This is different from the 401(k) or traditional IRA, which are both subject to required minimum distributions, or RMDs. These are IRS-mandated withdrawals you must take (and pay taxes on) starting at the age of 72.

The ability to leave your money invested in a Roth indefinitely is appealing because you can stretch the advantage of tax-free investment earnings. If you don't need the money to cover retirement living expenses, letting your money grow tax-free can be a powerful way to build an inheritance for your loved ones.

Just as you can stay invested in your Roth well into retirement, you can also keep contributing. There is no age limit on Roth contributions, but you can only contribute when you have earned income -- which is mostly wages and self-employment income.

Even if you've retired from your full-time career, you could still make Roth contributions if you have a part-time job, paid consulting projects, or gig work. You could deposit all your earnings from those activities to your Roth -- but not a penny more.

Sources of retirement income that you cannot send to a Roth are Social Security, investment income, interest or dividends, and pension payments.

If you bequeath your Roth IRA to your loved ones, those beneficiaries can usually keep the money in an inherited Roth IRA for 10 years. That should give your beneficiaries a full 10 years of tax-free investment growth -- which could easily be worth tens of thousands cumulatively.

There are some exceptions to the 10-year rule. Spouses, disabled beneficiaries, and chronically ill beneficiaries normally don't have to pull the money from the account in 10 years. Beneficiaries who are not more than 10 years younger than you may also be able to keep the money invested beyond 10 years.

Also, once the five-year rule has been met, the amounts your beneficiaries withdraw from an inherited Roth should be tax-free.

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Several characteristics differentiate a Roth IRA from other retirement accounts. But the differentiating point with the most value potential is that tax-free earnings growth. You can maximize that perk in three ways. Fulfill the five-year holding period, delay withdrawals at least until you are 59 and a half, and keep contributing as long as you have earned income. You can also pass on 10 years of tax-free growth to your heirs -- simply by leaving the money in the account.

That's a straightforward action plan with a ton of upside. Specifically, you could secure financial independence for yourself and, possibly, for your loved ones, too.

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