A Roth IRA is a type of individual retirement account that allows investors to enjoy tax-free growth of assets within the account as well as tax-free distributions from the account—so long as you play by the rules.
How Does a Roth IRA Work?
The concept of the IRA is relatively straightforward. The investor deposits money into their account and invests it, thereby designating it as reserved for their own retirement. In exchange for this prudence, the government gives the investor a tax break.
The nature of the tax break depends on the type of IRA. In the case of a Roth IRA, the investor does not receive a tax deduction for the money they contribute to their account. Instead, the money grows tax-free and may be withdrawn tax-free in retirement.
Roth IRA Example
Say an eligible investor were to deposit $6,000 into a Roth IRA today and invest it in various stocks, mutual funds, or exchange-traded funds, and, over decades, this balance grows to $50,000. If the investments are kept in the account, the investor will pay no taxes on dividends or other income generated in the account or on stock sales made in the account. And if the investor waits until they are at least 59 ½ years old to withdraw money from the account, they will pay no tax on distributions out of the account.
Distribution Options Before Age 59 ½
Roth IRA contributions are sometimes referred to as being made with “after-tax” money since investors don’t get a tax deduction for the money they contribute.
One potential benefit of this is that investors can withdraw up to the amount they’ve contributed to this type of account over the years at any time without paying any taxes or penalties. For example, if an investor makes a $6,000 contribution to a Roth IRA, they could withdraw up to this amount even before age 59 ½ without negative tax ramifications.
However, once the investor has withdrawn $6,000 from their account, any further withdrawals before age 59 ½ would be subject to regular income tax as well as a 10% additional tax unless an exception applies.
Benefits of a Roth IRA
Tens of billions of dollars flow into Roth IRAs every year, making them a very popular choice for retirement investing. Here are the major benefits:
- Tax-free growth. Money invested in a Roth IRA grows tax-free.
- Tax-free distributions. Assuming the account owner has had a Roth IRA for at least five tax years, all distributions taken out of a Roth IRA on or after the age of 59 ½ are tax-free. Investors may also withdraw contributions from their Roth IRA at any time, and other exceptions exist for tax- and penalty-free withdrawals before the age of 59 ½.
- Investment choices. Investors who open a Roth IRA at a major online brokerage can choose to invest in any security that they could through a taxable brokerage account. This is different from the typical 401(k) plan, which typically only offers a handful of funds as investment options.
- No required minimum distributions. Once the owner of a traditional IRA reaches the age of 72, they are required to start taking required minimum distributions out of their traditional IRA. This rule does not apply to Roth IRAs if the owner is alive, though the owner’s beneficiaries may be required to take distributions from an inherited Roth IRA after a certain period.
Drawbacks of a Roth IRA
As great as these financial tools are, there are some drawbacks to consider before incorporating one into your retirement plan.
- Contribution limits. In 2022, investors can only make up to $6,000 in combined contributions to all of their IRAs. This amount increases to $7,000 for investors age 50 or older.
- Must have earned income. An investor cannot contribute to an IRA—traditional or Roth—in excess of their earned income. So even though the maximum contribution amount this year for an investor under the age of 50 is $6,000, that investor could only contribute up to $5,000 this year if they only earned $5,000 from his job or business.
- Income limits. Investors with incomes over a certain amount are not eligible.
- Cannot borrow against the IRA. Unlike some 401(k) plans, investors cannot borrow against IRAs.
- May not be worth it for high-income taxpayers. These retirement accounts let investors trade the current-year tax deduction they could get for contributions to a traditional IRA in exchange for tax-free distributions when they retire. While this trade-off generally works well for individuals in lower tax brackets, it may not work as well for high-income taxpayers who may not benefit from trading a tax benefit now when they are in a higher tax bracket for a tax benefit later when they are in a potentially lower tax bracket in retirement.
Is it Right For You?
Roth IRAs provide significant tax benefits, especially for younger taxpayers in lower tax brackets who have many decades ahead of them to reap the benefits of tax-free growth.
However, if you do not necessarily fit this profile, you may find it useful to explore other retirement options appropriate for your situation. Consult with a tax professional to find out if a Roth IRA is the right choice for you.
This article is intended for general informational and educational purposes only, and should not be construed as financial or tax advice. For more information about whether a reverse mortgage may be right for you, you should consult an independent financial advisor. For tax advice, please consult a tax professional.