Here are some details on a Roth IRA.
What the heck is a Roth IRA?
Many of the most frequent questions I get are about Roth IRAs. What are they, who can qualify to contribute to one, how are they different from IRAs, and more.
So here’s a bit of information about what they are.
What is a Roth IRA and how is it different from an IRA?
IRA stands for Individual Retirement Arrangement, and is a type of personal retirement account for people who are working and wish to save for retirement.
Roth IRA accounts are a type of retirement account. The main difference between an IRA and a Roth IRA is the way they are taxed. The second main difference is related to the rules around withdrawing money.
- Contributions: Pretax. You pay no taxes now on the contributions. You pay taxes on the contributions when you withdraw them.
- Earnings: You owe taxes on all the earnings when you withdraw them.
- Withdrawals: You owe taxes on all withdrawals at ordinary income tax rates.
- Required Minimum Distributions: When you reach a certain age (currently age 72.5, this may be changing), you are required to make Required Minimum Distributions, which is a set amount you are required to withdraw that increases each year.
- Early Withdrawals: If you withdraw money from these accounts before you turn age 59.5, generally you will owe ordinary income taxes on the whole withdrawal, plus a 10% penalty for withdrawing the money before retirement.
Roth IRA Accounts
- Contributions: After tax. You pay taxes now on the contributions. You pay no taxes when you withdraw them.
- Earnings: You pay no taxes on the earnings when you withdraw them (assuming you are making a qualified distribution, typically meaning after age 59.5 but more about this later).
- Withdrawals: You pay no taxes on withdrawals if they are qualified distributions.
- Required Minimum Distributions: There are no required minimum distributions.
- Early Withdrawals: If you withdraw money from these accounts before you turn age 59.5, generally you will owe no taxes on the portion that is from your initial contribution. You will owe taxes on the portion that is from earnings, plus a 10% penalty for withdrawing the money before retirement. There are other rules around early withdrawals, including the 5 year rule, so talk with a professional before you make a withdrawal.
Basically, the main difference between the two accounts is how they are taxed, now or later. The other main difference is how the distributions are treated (withdrawals).
What is a qualified distribution?
There are several ways you can withdraw money from a Roth IRA without getting penalized by the IRS. First, you can withdraw the contributions you made anytime (remember, you already paid taxes on this money so you don’t owe taxes again).
Here are some other examples of qualified distributions:
- Withdrawals made after age 59.5
- Withdrawals of the earnings for education
- Withdrawals of the earnings for the purchase of a first home, up to $10,000
You can see that there are many different ways of taking advantage of this retirement savings tool.
Is a Roth IRA right for me?
There are many considerations regarding this question. Consult with your personal financial adviser to learn more about your situation. However, here are a few examples of circumstances that might make Roth IRAs a good choice for retirement savings.
- You are in a low tax bracket right now and expect to be in a higher tax bracket in retirement.
- You believe tax rates are going to increase over time.
- You earn less than $129,000 for a single tax filer in 2022. If you earn over $144,000 as a single tax filer, you aren’t eligible to contribute at all. This number changes regularly and varies based on how you file taxes; check out the IRS chart here (link opens in new tab). Also check out backdoor Roths, here (link opens in new tab).
- You have many years to go before reaching retirement, meaning you expect your earnings to grow significantly over that period.
This post has only really touched the surface of Roth IRAs. Want to read more? This Investopedia (link opens in new tab) article has some additional information. Or, here’s a link to learn about Backdoor Roths. Also please note that these rules are all subject to change when Congress passes different laws or the IRS issues guidance, so be sure to research the most recent information on Roth IRAs as well, or ask your adviser.
Have more questions?
Your personal financial adviser can help you in your particular situation. The above is informational only and is not intended as investment advice or as a personal financial recommendation.