What is a Roth IRA?

A Roth IRA is an individual retirement account that allows people below a certain income ceiling to contribute a fixed amount of money each year and invest it for their retirement.

While a traditional IRA requires you to pay taxes when you withdraw the money, a Roth IRA allows you to pay taxes on your income now, so in most cases, you can withdraw your money (and earnings) in retirement without paying additional taxes. Roth IRAs can be beneficial for some retirement investors, especially those who expect to be in a higher tax bracket in the future. The income and contribution limits for Roth IRAs change frequently, and people who are 50 or older can contribute more.

A Roth IRA is like a Redwood tree…

You pay for the sapling today, as well as all the supplies it will take to grow the tree. You put in some effort over the years to make sure that the tree is maturing on the right path. When you’re older and ready to retire, part of your tree may have grown mighty and tall, while some branches may have broken off or withered away. But at that point, you won’t have to pay more money to enjoy the tree’s shade — You can just hang a hammock and relax.

A Roth IRA is a type of individual retirement account that allows people to save money, invest it, and reap certain tax benefits. With a Roth IRA, you pay taxes on your income before you make a contribution, and you won’t owe additional taxes if you withdraw the money according to federal rules. To contribute directly to a Roth IRA, you must earn some income but stay below a certain ceiling. There are restrictions on how much you can directly contribute each year and when you can make withdrawals.

Roth IRAs and traditional IRAs are both retirement accounts that individuals open on their own, rather than through an employer. Both restrict how much you can contribute each year, allow you to invest your savings in a variety of assets, and come with tax advantages. One key difference between them is eligibility. Anybody can contribute to a traditional IRA (though deductibility rules vary) , but only people below a certain income limit can directly contribute to a Roth IRA. Another difference lies in how the accounts are taxed. With a Roth IRA, you pay taxes on your income before making contributions, but withdraw the money, including earnings, tax-free in most cases. With a traditional IRA, you can deduct contributions from your income when you file your tax return, but you pay taxes on the money when you withdraw it.

Roth IRAs and 401(k)s are both retirement accounts, but they differ in important ways.

Roth IRAs are under your control — You can decide whether to open one and where. You can only use a 401(k) if your employer offers one, although people who work for themselves may open a self-employed 401(k), or SEP 401(k).

Both accounts often allow you to invest in assets like stocks, bonds, mutual funds, and more. However, Roth IRAs may come with a broader variety of investment options. With a 401(k), you may have limited investment options, though you will benefit from certain legal and fiduciary protections.

While the tax benefits between Roth IRAs and Roth 401(k)s are similar, the tax benefits between Roth IRAs and traditional 401(k)s are different. Roth IRAs require that you pay taxes when you contribute, but let you make tax-free withdrawals. With a traditional 401(k), you deduct contributions from your taxable income in the year that you make them, but then pay income tax on withdrawals.

In order to contribute to a Roth IRA, you must earn some income. But if you make too much in a certain year, you can’t directly contribute the full amount, or sometimes anything at all. However, you may be able to engage in a “Backdoor Roth” if you engage in a series of specific steps. (A “backdoor Roth” typically refers to a traditional 401k or IRA that has been converted into a Roth IRA, which investors sometimes do to seek future tax savings).

The income limits for a Roth IRA use your modified adjusted gross income (MAGI). To get your MAGI, first figure out your adjusted gross income (AGI) by starting with your total income and subtracting certain tax-deductible expenses such as:

• Certain retirement account contributions
• Student loan interest
• Health Savings Account contributions
• Alimony paid

Then, you add back in things like IRA contribution deductions, student loan and tuition deductions, rental losses, half your self-employment tax, and more.

Unlike employer-sponsored retirement accounts, such as 401(k)s, you can open a Roth IRA on your own. You have discretion on the timing of your contributions — For example, you don’t have to fully fund the account when you open it. Once you make contributions, you can allocate funds to the investments of your choice, such as stocks, bonds, mutual funds, or even real estate. You can adjust your portfolio as you see fit over the years.

It’s possible to lose money in a Roth IRA, just like it’s possible to lose money with any investment. For example, if you use the money in your Roth IRA to invest in a mutual fund, and the fund’s share price decreases, you’ll lose money.

The risk of losing money will depend on what types of investments you make in your Roth IRA. If you keep your money in cash, you may have less risk of nominal investment losses, but it also won’t grow and would actually lose value due to inflation. Generally, the more your portfolio is in stocks, as opposed to bonds and cash equivalents, the higher your potential for both growth and your risk of losses.

The greatest benefit of a Roth IRA is that the account is tax-advantaged. Unlike with a traditional IRA or 401(k), you don’t have to pay taxes when you withdraw money from the account if you do so according to federal guidelines. Instead, you pay taxes on the funds before you deposit them. This can be advantageous for people who anticipate being in a higher tax bracket when they retire or who want to diversify the way their retirement accounts are taxed. And, unlike with a taxable brokerage account, you won’t pay income or capital gains taxes on your earnings if your investments gain value.

Another perk of a Roth IRA is the ability to withdraw contributions (but not your earnings) whenever you’d like without paying penalties or taxes. You can also withdraw some earnings tax-free in a few other scenarios, such as when you’re buying your first home or need to pay certain medical bills. The greatest drawback of a Roth IRA is the restriction placed on the withdrawal of earnings. If you tap your earnings before you turn 59½ and the contribution is less than five years old, you’ll have to pay a 10% penalty. (The exception is if you meet other criteria, such as becoming permanently and completely disabled.)

Roth IRAs also generally have lower contribution limits than retirement accounts like a 401(k) or SEP IRA. You’re also banking on being in a higher tax bracket when you retire. By paying taxes up front, you’re locking yourself into your current rate even though there’s a chance your future tax rate might be lower.

To be eligible to directly contribute to a Roth IRA, you must have earned income in the previous tax year. If you do not have any income, or only have unearned income, you are not allowed to contribute to a Roth IRA.

Examples of eligible income include:

• Wages
• Salaries
• Tips
• Income from contract or freelance work

Examples of ineligible income include:

• Pensions
• Unemployment benefits
• Worker’s compensation

There’s an exception: You can open a Roth IRA even if you don’t have earned income as long as your spouse does. In order to do this, you must file taxes jointly and your spouse must earn at least as much as you contribute to your Roth IRA and your spouse’s Roth IRA combined. All income limits still apply.

Because Roth IRAs are retirement accounts, withdrawals are restricted. You can take out your contributions anytime without paying penalties or taxes. But you can only withdraw earnings without doing so if you’re at least 59½ years old, and opened the Roth IRA at least five years ago. You can also make withdrawals if you meet one of the following requirements:

• You’re withdrawing $10,000 or less to buy your first home
• You use the money for certain qualifying educational expenses, such as tuition and fees
• You become totally and permanently disabled, meaning you:
  • Can't engage in any substantial gainful activity because of a physical or mental condition AND
  • A qualified physician determines that the condition has lasted or can be expected to last continuously for at least a year or can be expected to result in death.
• You use the funds to pay for medical expenses that were not reimbursed by insurance or insurance premiums while unemployed
• You set up a substantially equal periodic payment (SEPP) plan

If you do not meet these requirements, you may owe a 10% penalty and income taxes on any earnings you withdraw.

There are limits to the amount you can contribute to a Roth IRA each year. You can review those limits on the IRS website. There is no limit on the size of your account, so your investments can grow without a cap if they gain value.

There are no guarantees when it comes to investing, but you can use a compound interest calculator to project how your Roth IRA’s balance may grow over time. By entering your starting balance, annual or monthly contributions, and an estimate of your rate of return, you can estimate how your Roth IRA might grow over time, especially as you near retirement.

You can find information on the average rates of return for different investments from a variety of sources, including investing websites or newspapers. Remember that your investments’ earnings will compound each year. That means that you can earn returns on the returns you’ve already earned, potentially accelerating your Roth IRA’s growth. Roth IRAs are designed for long-term savings. When you invest in the stock market, there may be short-term ups and downs in your account’s value.