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Planning and Investing

The complete guide to Roth IRAs

Picture your retirement years. Do you envision yourself enjoying trips on cruise ships, sipping cocktails, and being first in line at the buffet? If so, you'll need to start looking out for 'future you' ASAP. If you're smart, you can invest in a Roth IRA and enjoy bumper tax-free withdrawals in retirement.

Keep reading to learn everything you need to know about Roth IRAs, including what makes them different from other IRAs, income limits, contribution limits, how to start a Roth IRA, and more.

What is a Roth IRA?

An individual retirement account (IRA) is a type of savings account that offers awesome tax benefits. Roth IRAs crank the tax advantages up a notch by offering tax-free income for your retirement.

With other savings options, you invest money, pay tax on the interest, and pay tax when you make a withdrawal. But this isn’t the case with Roth IRAs. When it comes to these nifty guys, you pay tax now and sit back and watch as your earnings grow tax-free. Then, when the time comes to draw on those savings, you can withdraw them without paying taxes.

There are a bunch of other benefits, too, but more on those later. First, let's get into the details of how Roth IRAs work compared to traditional IRAs and other pension plans.

Roth IRA vs. other retirement savings options

There's no one-size-fits-all retirement solution. The best option for you depends on factors such as your tax bracket and expected tax rate at retirement age, as well as your personal preference. 

Roth IRAs can be ideal for those who expect a higher tax bracket once they hit retirement. With this type of saving plan, you'll avoid paying more tax in the future by investing at your current income tax rate. So, if you're just getting started in your career and you're on a lower income, a Roth IRA could be just the ticket.

Other retirement plans include:

  • 401(k): If you work for a for-profit employer, they might offer this type of pension plan. A percentage of your income is taken from your paycheck and invested into assets chosen by your employer, who may match your contributions. When you withdraw that money, it's taxed at your tax rate at the time of retirement — unlike a Roth IRA, which is completely tax-free. 

  • IRA: With a traditional IRA, you make tax-deferred payments to investments that contribute to your retirement savings. That means your money isn't taxed until you make a withdrawal — BTW, you have to start doing so at age 72. There are no income limits, which a Roth IRA does have, but the latter lets you withdraw tax- and penalty-free funds once you reach 59 and a half (although you're never obligated to do so).

  • SEP IRA: If you're self-employed or a small business owner, the SEP IRA is an option. It's pretty much a cross between a traditional IRA and a 401(k), with the same rules as the former and similar maximum contribution levels as the latter. One major benefit is that you can skip making contributions during years when business is slow. 

How does a Roth IRA work?

A Roth IRA lets you invest money you've already paid taxes on into a savings account for your retirement. It's worth thinking about this type of investment, especially if you're in a lower tax bracket and plan on earning more later in life. There may be years ahead of you to rack up that tax-free bag.

You can use your income to invest in assets such as mutual funds, stocks, bonds, and ETFs. As your investments grow in value, your Roth IRA balance follows suit. You can invest in a diverse range of securities and relish the tax shield provided by the plan. 

Roth IRA income and contribution limits 

Unlike traditional IRAs, there are income limits on Roth IRAs. The IRS updates the maximum "modified adjusted gross income" (a fancy term for income) each year, which means eligibility can change. If you're ballin' and earn over a certain threshold, you might need to reduce or discontinue your contributions.

Take a look at the table below for the Roth IRA contribution and income limits in 2023.

Filing Status

2023 MAGI

Contribution Allowance

Single, head of the household, or married and filing separately (living apart)

<$138,000

$7,500 over 50 and $6,500 under 50

>$138,000 but <$153,000

Reduced contribution

>$153,000

No contribution 

Married, filing jointly

<$218,000

$7,500 over 50 and $6,500 under 50

>$218,000 but <$228,000

Reduced contribution

>$228,000

No contribution 

Married, filing separately (living together)

<$10,000

Reduced contribution

>$10,000

No contribution

When can you withdraw from a Roth IRA?

There are a few important tidbits to know about when and how you make withdrawals from your Roth IRA. 

The 5-year rule

You can't withdraw tax-free funds from your account until you've held it for at least 5 years. Once you qualify:

  • If you're under age 59 and a half, withdrawals are subject to taxes and a 10% penalty. However, you could avoid these if you have a permanent disability, use the money to purchase a first home, or if your distributions are passed on to an heir.

  • If you're over age 59 and a half, you reap the full benefits of your Roth IRA and won't pay any taxes or penalties (all distributions are qualified).  

If you don't yet qualify for the 5-year rule:

  • If you're under age 59 and a half, you pay taxes and the penalty. However, you can avoid the penalty if you have a permanent disability, use the money for a first-time home, pay for qualifying education expenses, have unreimbursed medical expenses, have birth or adoption expenses, or your distributions are passed on to an heir.

  • If you're older than 59 and a half, you pay taxes but no penalty.

Nonqualified withdrawals

You can take out cash from your Roth IRA at any time. However, you'll likely be subject to a pesky 10% penalty plus taxes if you access funds before you reach 59 and a half. Any distributions that don't meet the criteria above are nonqualified withdrawals.

There are notable exceptions, such as:

  • Having unreimbursed medical expenses over 7.5% of your annual gross income

  • To cover medical insurance in case of unemployment

  • You're permanently disabled

  • You get distributions as an annuity

  • The money goes toward buying, building, or rebuilding a first home

  • Paying qualified birth or adoption expenses 

Can you have a Roth IRA and a 401(k)?

Let's face it, no one views a savings account full of money and wishes they hadn't put so much away. On the other hand, everyone who reaches retirement age and doesn't save enough regrets it — and finds it harder to pay their bills. 

You can never save too much. If the option of having a Roth IRA and 401(k) account is open to you, embrace it with open arms. You'll get maximum tax breaks and have access to more cash once you reach your golden years.

Let's look at how the two differ: 

  • Roth IRA: You open this type of retirement account as an individual and pay money that you've already paid taxes on. No income tax is paid on withdrawals, and you have the option of selecting which assets you invest in.

  • 401(k): Only people whose employer offers this type of account can benefit from it, and you don't pay taxes on contributions. Employers often match your contributions, bumping up the amount you save, but they have the power over which securities are invested in. Withdrawals are taxed according to which income bracket you're in once you reach retirement.

Benefits of investing in a Roth IRA

Savvy investors love a Roth IRA for its robust tax benefits. This is especially true if you think you'll be in a higher tax bracket when you retire and you have this type of retirement account. 

Instead of paying the higher tax rate as you would with a traditional IRA, you'll have access to tax-free cash that you invested while paying less tax. It's a win-win. Plus, let's not forget about the uber-villain known as inflation. By paying a lower tax rate on your Roth IRA contributions in the present, you can potentially offset rising rates in the future. 

Tax and cash flow benefits

There are even more tax advantages to having a Roth IRA: 

  • Withdraw the money you put in (not the profits) at any time, without paying any taxes or penalties.

  • Double dip and lavish in the proceeds of your Roth IRA and 401(k) once you reach retirement age.

  • Choose the timing of your contributions and split them over the course of a year if necessary.

  • As long as you have earned income, you can open a Roth IRA at any age.

  • Boost your Social Security payout by 8% by delaying your access to it for the maximum period. Use your Roth IRA tax-free cash flow to cover costs until you reach age 70, and then enjoy a boosted Social Security check thereafter.

Inheritance Loophole

With 401(k) and traditional IRA accounts, there are required minimum distributions. This means you're obligated to start making withdrawals at age 72. However, with a Roth IRA, you can transfer your wealth tax-free, without ever making any withdrawals. 

There aren't many ways to keep the IRS away from your hard-earned cash, but Roth IRAs provide a lucrative loophole. 

Picture the future. You've reached senior status, and let's say you have a beloved grandson. He has a great job in computer science and is in the highest tax bracket. With an inherited 401(k) or traditional IRA, he'd have to pay tax on the money you leave him at an astronomical rate.

What's more, once you reach 72, you're obligated to make withdrawals. Any income in your bank account is likely to be subject to inheritance tax when you pass.   

On the other hand, say you have a Roth IRA. If it grows to $600,000 over the 25 years it takes to reach retirement, you can leave the total sum to your grandson. You don't have to tap into it and deplete it at all, and he can draw on that IRA in all its tax-free glory if he is designated as your beneficiary or heir. 

How to start a Roth IRA

Anyone can start a Roth IRA whenever they choose, so long as they have income. You can open one through your local credit union or any IRS-approved broker. 

Be sure to go through the investments you can select from with a fine-toothed comb, and make sure there are plenty of options. Depending on how much of a finance aficionado you are, you might opt for a seller that lets you make decisions on your own vs. offering advice for beginners.

The account can hold a range of securities, including mutual funds, bonds, and stocks, and you make contributions using cash or checks. 

Backdoor Roth IRA

If you have a traditional IRA, you might consider Roth IRA conversion during a market downturn. In a bear market, the value of your IRA is likely to decrease — usually just in the short term. Because the IRA's dollar value is lower, you pay less in taxes than you would in a bull market.

In other words, you can offset the IRA's loss of value by taking advantage of the lower tax hit. Plus, future you will benefit from tax-free withdrawals once you've held the account for more than 5 years. 

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