What is a Roth IRA & How It Works?

It’s easy to achieve financial success with a Roth IRA once you understand distributions, withdrawals, limits, advantages, and disadvantages.

Roth IRAs are a common option for retirement, but the details surrounding them can be confusing. From tax breaks to withdrawal penalties, there’s a lot to learn, and plenty of specifics that you need to understand before making a commitment.

You can make a decision about whether a Roth or a traditional IRA is better for you once you have an understanding of how it works and what the requirements and limitations are. 

How could a Roth IRA lead to a more comfortable, less stressful future for you and your family?  Whether you have already made some investments for retirement, or you do not even know what IRA stands for, read on to find out.

Then, if a Roth IRA is the right fit, you can learn how to open an account, too.

What is a Roth IRA?

A Roth IRA is an individual retirement account that has advantages as an investing tool over a traditional IRA for many of us.

The Roth IRA and the traditional IRA are the most popular types of retirement accounts.  Named after Senator William Roth of Delaware, who sponsored the legislation that led to its creation, the Roth IRA has existed for more than 20 years. 

How Does a Roth IRA Work?

Unlike contributions to traditional IRAs, contributions to your Roth IRA are not tax-deductible. It is crucial to remember not to deduct any of your Roth IRA money when you file your taxes.

The benefits come down the road when you start withdrawing your cash because then it is tax-free. You will need to wait until you reach age 59 ½ to access all of your money, however.

Your Roth IRA will benefit you the most if you invest the funds. You have many choices of how to invest, including mutual funds or stocks and bonds, among others.

And you will want to add money each year so that your retirement fund can continue to grow.

Roth IRA Distributions & Withdrawals

In 2024, the maximum contribution is $6,000 if you’re under 50. If you’re 50 or older, it is $7,000. Those 50 and older will be able to catch up a bit even if they neglected to start the process earlier.

You can withdraw contributions tax-free whenever you wish. If you withdraw account earnings (as opposed to your contributions) before you reach age 59 1/2, you could face a 10% penalty.

You also need to have the account for at least five years before making withdrawals.  Be cautious, because 10% can be a big hit to take if you need to withdraw a substantial amount.

But this is one case where the IRS is on your side because they will assume any initial money you take out is from your contributions.  There are, however, a few situations where you could qualify to withdraw your Roth IRA earnings sooner.

These include buying your first home, paying college expenses, adopting a child, and becoming disabled. There are several others.  Since early 2020, more people than ever seem to be running into emergencies.

With a Roth IRA, it helps to be able to get your contributions back for emergencies if needed at any time. Experts do not recommend these withdrawals, but you can if you feel you must.

There are new special allowances under the CARES Act if you need to withdraw funds from your Roth IRA due to yourself or your spouse being diagnosed with COVID-19.

The test you take must be one that the Centers for Disease Control has approved.  These funds are called Coronavirus Related Distributions, CRDs. 

In the unfortunate event that you needed to take this route, you would have three years to put the money back in your Roth IRA.

Roth IRA Limits in 2024

Sometimes the rules for retirement accounts can change, but here’s what you currently need to know.  To fully understand how a Roth IRA works, you need to learn about the MAGI. 

That is not a Star Wars character: it’s your Modified Adjusted Gross Income.  If you are married and filing jointly, you and your spouse can each make a $6,000 contribution if your adjusted gross income is less than $196,000.

If you are single or married but filing individually, you can make the $6,000 Roth IRA contribution with an income under $124,000. 

If your spouse is not currently employed, you can still make Roth IRA contributions for him or her. You will need to set up a second account in your spouse’s name because you can’t hold Roth IRA accounts jointly. 

The rules that apply to your Roth will apply to your spouse’s, and in this situation, you will need to file and pay income tax jointly. It might be worth any extra effort because it allows you to double your savings each year.

Roth IRA vs. Traditional vs. 401(k)

With a traditional IRA or 401(k), you get your tax deduction at the time you make your contribution. That makes the conventional IRA seem attractive to a lot of people.

Remember, the Roth IRA is about a tax free income in the future.  One benefit of the Roth IRA is that your balance won’t be taxed as it multiplies or if you withdraw it after you retire.

It’s delayed gratification, and that gratification can be tremendous.  If that’s important to you, you can convert your traditional IRA to a Roth with few restrictions.

You can be flexible in the way you contribute. Make your annual contribution all at once or make several smaller contributions during the year.

Currently, you can even wait until the tax deadline to add money for the last calendar year.  You can even save money on future Social Security and Medicare expenses.

The government considers withdrawals from a traditional IRA part of your income when any of your Social Security benefits are taxed. You won’t face this with funds you withdraw from your Roth.

Similarly, if your income level means Medicare will cost you more, your Roth IRA withdrawals won’t make a difference in these charges.

You may also keep an existing 401(k) and open a Roth IRA if you wish. The contribution limit on a 401K is currently much higher, at $19,500 for 2024.

However, you will pay taxes on that money once you withdraw it in retirement, whereas with a Roth IRA you would not.  Maybe at your particular job, a 401K is not offered?

Then a Roth IRA is worth considering.  One more benefit is that there won’t be any Required Minimum Distributions once you’re in your 70’s as there sometimes are with other types of retirement accounts.

How to Open a Roth IRA Account

First and foremost, you need to make sure your earned income is under the required limit. One example of income that isn’t earned would be income from any rental property you might own.

And of course, a government-issued photo ID, social security number, and bank information.  Then consider your options before going directly online to your bank.

Check out a few brokers to determine if they can help you accumulate more money in the long run. Most people choose to use a broker, especially those who want to choose their investments.

Upon deciding where to get started, you can go online to complete all the required documents.  Next comes the most challenging part for many of us: deciding how to invest.

If you’re not the type who considers this fun, there are many resources available to help you.  One such resource is a robo-advisor. It may sound like something from an action movie, but it’s just a service where a computer chooses your investments and build your portfolio.

It’s based on when you plan to retire and how comfortable you are taking risks. It’s known as automated investing.  In general, you’re safer making riskier investments at a younger age and will want to become less risky as you get older. 

Finally, commit to contribute! Just like with the 401(k) you’ve probably heard about at work, if you don’t contribute to your Roth IRA, you won’t reap all the great benefits.  

Tell your kids or grandkids, and they can start a Roth IRA too. The younger, the better! They should start now if they want even more money than you will have in retirement.

All they need is a job, even if it’s part-time or temporary.  If they don’t start soon, they will wish they had later.  You can even leave your Roth IRA to them in your will, and the funds will remain tax-free once you’re no longer around to withdraw them.

So be sure to designate a beneficiary when opening the account and remember to update the information if you ever need to.

Next Steps

Let’s recap. A Roth IRA is a retirement account where you save your money and pay taxes on it now, then reap the benefits of tax free withdrawals in the future.

It’s not for the very wealthy, but it’s excellent for much of the population.  You can get one started even with very little cash on hand.

A Roth IRA can be especially helpful if you are in a situation where your taxes might get higher after you retire. In today’s world, with COVID-19 and increased government spending, this seems a possibility for more of us every day. 

Roth IRAs are also good if you’re a younger investor because you have a greater chance to move into higher tax bracket due to earning more taxable income as you get older and advance in your career.

Don’t be intimidated if you’re new to the world of saving for retirement. The effort to get going will be well worth it before very long.

You and your family can now get ready to make your plans and establish a Roth IRA so that later, you can enjoy the retirement of your dreams.

FAQ's

Here are quick answers to common questions about Roth IRAs.