February 21, 2024

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What Is a Roth IRA? Rules, Benefits & How to Invest

Roth IRA meaning

A Roth IRA is an individual retirement account that has special tax advantages: Distributions from the Roth IRA in retirement are tax-free, because the money contributed is taxed. You can withdraw contributions to a Roth IRA without tax or penalty.

This is unlike a traditional IRA, which offers a tax deduction when you contribute but requires taxes owed on distributions in retirement.

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How does a Roth IRA work?

You contribute to a Roth IRA with after-tax dollars, which essentially means there is no immediate tax deduction or other tax benefit for contributing to the account. Once your account is funded, you can invest that money through the Roth IRA. Over a long time horizon, those investments will likely earn a return.

That’s when the real benefit of the Roth IRA kicks in: Qualified withdrawals from the Roth IRA during retirement (defined here as after age 59 1/2) are tax-free, because you didn’t receive a tax benefit when you funded the account. This includes all of the investment growth we just referenced, which would otherwise be taxed.

Additionally, because you paid taxes on the contributions before putting them into the Roth IRA, you can withdraw those contributions — but not investment earnings — at any time without additional taxes or penalties from the IRS.

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What are the Roth IRA contribution and income limits?

There’s a hitch, which is that IRS sets income eligibility limits for Roth IRAs. You can fund a Roth IRA as long as your income is under the limits below; at higher income levels, the amount you’re allowed to contribute is phased out and, eventually, eliminated completely.

Maximum annual contribution

Single, head of household, or married, filing separately (if you didn’t live with spouse during year)

$6,500 ($7,500 if 50 or older).

More than $138,000, but less than $153,000.

Married filing jointly or qualifying widow(er)

$6,500 ($7,500 if 50 or older).

More than $218,000, but less than $228,000.

Married filing separately (if you lived with spouse at any time during year)

If you don’t qualify for a Roth IRA, you have the option of contributing to traditional IRA, then converting that account to a Roth IRA through a method called the backdoor Roth (also known as a Roth IRA conversion). This type of conversion allows you to transfer money from your traditional IRA into a Roth IRA, but you have to pay taxes on the money first. There are no restrictions on income limits or marital status for backdoor Roths, so anyone is eligible to open one.

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What are the benefits of a Roth IRA?

What makes a Roth IRA so attractive to investors is the potential tax savings. If you think you’ll be in a higher tax bracket when you retire than you are now, a Roth IRA may be more beneficial than a traditional IRA. The reason: You’ve already paid taxes on your contributions, so your higher tax bracket won’t result in a high tax bill when it’s time to enjoy your hard-earned money.

Another reason the Roth IRA is attractive is rising inflation. Inflation erodes the value of money over time. Giving your money an opportunity to grow tax-free is lucrative.

  • No required minimum distributions: Account holders of Roth IRAs aren’t subject to the required minimum distributions required of traditional IRA or 401(k) accounts

  • No income tax on inherited Roth IRAs: If you pass a Roth IRA to a heir, they enjoy tax-free withdrawals as long as the account was held for at least five years at the time of the account holder’s death.

  • Easy withdrawals: You can withdraw the money you contributed any time, without taxes or penalty. (You may be taxed or penalized if you withdraw investment earnings.)

  • Double dipping: You can contribute to a Roth IRA in addition to an employer retirement account like a 401(k).

  • Flexible timing: You can choose when and how much you contribute to a Roth IRA. For example, you could contribute the full limit on the first day of the year, or split up your contributions throughout the year.

  • Extra time to contribute: You have until that year’s tax deadline to contribute for the previous calendar year, which usually falls in mid-April.

  • Tax-free distributions: Once you hit 59½, and have held the account for at least five years, you can take distributions, including earnings, from a Roth IRA without paying federal taxes.

  • No age limit to open: You can open a Roth IRA at any age, as long as you have earned income (you can’t contribute more than your earned income).

How do you invest in a Roth IRA?

Investing in a Roth IRA is pretty straightforward once you’ve met the income requirements to contribute to the account. First, decide whether you want to do passive or active investing, and choose the best Roth IRA provider for your investing approach.

For example, if you aren’t keen on the idea of constantly watching the stock market and trading, you may want to do passive investing and use a robo-advisor. Robo-advisors do all the work of choosing and managing investments for you based on your investing goals. If you enjoy managing your own investments, investing in individual stocks, or advanced investing strategies like day trading or options, then opening a regular Roth IRA brokerage account may be the better option.

There are several types of securities you could invest in using your Roth if you choose a more hands-on approach to investing. Some of them include:

What are the Roth IRA rules?

Here are a few withdrawal and distribution rules you must follow:

Roth IRA withdrawal rules

  • You can withdraw your original contributions whenever you want, without owing any penalties or taxes, no matter how long your account has been open. That’s because the money you put in is money you’ve already paid income tax on.

  • When you withdraw money from a Roth IRA, the IRS always assumes your original contributions come out first.

  • People at least 59 1/2 years old, and who hold their accounts for at least five years, can take distributions, including earnings, without paying federal taxes.

Roth IRA withdrawal penalty

Qualified withdrawals of investment earnings in the account come out tax-free. The key here is “qualified.” If you withdraw earnings before 59 1/2, or otherwise don’t meet the rules for a qualified withdrawal, the IRS may want a piece of those returns, in the form of taxes and a possible penalty. Examples of qualified withdrawals before age 59 1/2 include a first home purchase, qualified education expenses, health insurance premiums while unemployed, disability related expenses, having a baby or adopting. Be sure you understand all the rules of these exceptions.

What’s the difference between a Roth IRA and a traditional IRA?

The main difference between a Roth IRA and traditional IRA is how they’re taxed. Roth IRAs give you tax-free withdrawals in retirement, while traditional IRAs give you a tax break when you contribute. So, if you want an immediate tax break, consider a traditional IRA. If you like the idea of tax-free income in retirement, Roth IRAs might be a better option for you. You can read our Roth IRA vs. traditional IRA article to learn more about the differences.

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