Roth IRA

A Roth IRA, which stands for a Roth individual retirement arrangement, is a tax-advantaged investment meant for retirement. With a Roth IRA account, you can contribute after-tax funds into the account and withdraw it at retirement age (59 ½), tax-free.

Roth IRAs are a flexible and liquid investment where you can choose to withdraw any of your funds after at least five years of opening your account without worrying about taxes. However, note that if you withdraw your funds earlier than planned, any profit or growth resulting from the investment will be taxed, and you may have to pay a penalty.

Having access to a Roth IRA is vital for the 33% of private industry workers who have no access to employer-provided retirement plans. It is a convenient way to plan and save for their expenses later in life. Even workers with workplace-based plans can take advantage of this investment, as it can serve as an extra retirement cushion.

A Roth IRA is a type of tax-advantaged investment meant for retirement. Contributions made to your account are from after-tax funds, and as a result, growth and withdrawals are tax-free. Anyone can open and contribute to a Roth IRA account up to a limit of $6,500 for 2023. The limit is $7,500 for those older than 50.

Being able to enjoy your retirement without worrying about taxes is one of the main benefits of a Roth IRA, but certain conditions apply. To enjoy tax-free withdrawals, you must have an account open for at least five years, and withdrawals should be made when you are at least 59 ½ years old. If you withdraw funds without meeting these conditions, the money you take out may be subject to a 10% tax penalty and income tax.

Roth IRAs are also similar to traditional IRAs, but there are differences in taxes, what you have access to and eligibility requirements. For instance, traditional IRA contributions are tax-deductible, lowering your taxable income for the year that you make contributions. However, when you retire or need cash from your account, anything you take will be taxed at your income tax rate at the time of withdrawal, which can benefit you if you expect to be in the same or a lower tax bracket when you retire.

Not all types of income can be used to contribute to a Roth IRA, as contributions must come from earned income or taxable compensation. Taxable compensation includes wages, salaries, commissions, tips, bonuses or net income from self-employment. However, compensation from passive income, such as earnings or profits of property, interest and dividend income, pension or annuity income, are not counted and cannot be used to contribute to a Roth IRA.

Aside from your income source, Roth IRA contributions also depend on income amount, such as your modified adjusted gross income (MAGI).

An individual's modified adjusted gross income (MAGI) is calculated after considering certain deductions and tax penalties. In terms of a Roth IRA, individuals with MAGIs over a specific level may limit how much they can contribute or whether they can contribute.

For the tax year 2023, the thresholds are as follows:

• For individuals filing as single or as the head of the household, you can make limited contributions if your MAGI is at least $138,000 but no more than $153,000.
• For married couples filing jointly or qualifying widow(er)s, you can make limited contributions if your MAGI is at least $218,000 but no more than $228,000.
• For married couples filing separately, you can make limited contributions with a MAGI of more than zero, but no more than $10,000.

How much you can contribute to your Roth IRA will depend on your filing status and your MAGI. Review the maximum contribution limits below to determine how much you can give based on your situation.

Source: Amount of Roth IRA Contributions That You Can Make for 2022, Internal Revenue Service (IRS)

While the typical contribution limit for a Roth IRA is $6,500, some individuals with a specific filing status or income level may have a reduced limit. To ensure that low- and middle-income earners continue to benefit from tax-advantaged accounts and prevent high-income earners from receiving an unfair advantage, the IRS limits the amount taxpayers can invest in Roth IRAs.

The IRS requires the following filers to have reduced contributions:

Roth IRAs have more flexible withdrawal rules than traditional IRAs, but some requirements and penalties can apply depending on your withdrawal purpose. Generally, there are two withdrawal types: qualified distributions and non-qualified distributions.

A qualified distribution is a tax-free and penalty-free withdrawal, which typically requires that you meet the IRS’ requirements. To be counted as a qualified distribution, your Roth IRA account must have been active for at least five tax years, and your withdrawal must be:

• Made on or after you turn 59 ½ years old
• Taken due to a permanent disability
• Requested by your estate or beneficiary after your death
• Used to build or buy your first home (up to $10,000)

If the conditions for a qualified distribution are not met, it will count as a non-qualified distribution. This is where taxes or penalties can apply.

No taxes will apply if you withdraw from your contributions, but a 10% penalty applies. If you withdraw from your earnings, you will pay taxes on said earnings at an ordinary income tax rate and the 10% penalty.

However, the 10% penalty may be waived if your purpose for withdrawal falls under the following reasons:

• You are taking a series of equal distributions
• You have medical expenses, not eligible for reimbursement, exceeding 10% of your MAGI
• You need to pay for health insurance premiums after suffering unemployment
• You need it for an IRS levy
• You are taking qualified reservist distributions
• You need to pay for eligible education costs
• You need to pay for childbirth or adoption up to $5,000

Understanding exactly how your withdrawal will work can help you determine when you should get funds from your Roth IRA. After all, you may find that your purpose falls under an exemption if you need to withdraw earlier than usual.

A Roth IRA can be confusing, especially compared to its cousin, the traditional IRA. Review the most frequently asked questions below to gain clarity regarding the Roth IRA.

Retirement planning requires care, as you’ll want to ensure that your life post-work is secure. Review MoneyGeek’s other resources below.

• Planning for Financial Success & Happiness: If you have long-term financial goals other than retirement, learn how to create a financial plan that will lead you to success.
• Smart Spending in Retirement: The majority of retirees live on a fixed income, so it is crucial to make smart money moves early on to keep your standard of living in retirement. Learn how to design a financial plan and minimize your risk of outliving your savings.
• Older Adults' Guide to Income Streams and Money Management in Retirement: With proper planning and strategies, you can maximize your finances safely and successfully in retirement.
• Save It Like You Mean It: The (Non-Scary) Guide to Retirement Planning: Learn about retirement planning and what it entails in this MoneyGeek guide.
• The Social Security Guide: Know how to take Social Security and how to maximize your benefits.