Everything You Need to Know on How Does a Roth IRA Work
Last Updated: March 23, 2022
If you’ve been planning for retirement, you must be asking yourself where to invest your money. Roth accounts are a great option. But how does a Roth IRA work? What are the benefits of such an account?
In this article, we shed light on your questions about such accounts: their benefits, requirements, limitations, and other crucial information to help you secure your retirement fund.
What Is a Roth IRA?
Roth IRAs, established in1997, were named after Senator Roth, a former Delaware Senator from the US. A Roth IRA (individual retirement account) allows you to contribute after-tax dollars and withdraw a contribution, tax-free. This is especially helpful for those who feel taxes are so complicated.
Roth accounts don’t have contribution age restrictions. You can contribute regardless of how old you are, provided you have earned income. There are also no required minimum distributions (RMDs)—your savings continue to grow, even during retirement. And when you pass your Roth IRA onto your beneficiaries, their withdrawals will also be tax-free.
|NOTE: Roth IRAs can double as your emergency fund—you can withdraw at any time for any reason. Tax and a penalty fee only apply when you withdraw your gains.|
How Do Roth IRAs Work?
Traditional IRA contributions are made with pre-tax dollars, which means you pay income tax when you withdraw a distribution. Roth IRA contributions, however, are made with after-tax money, meaning your contribution withdrawals are tax-free. There’s no minimum age requirement to make Roth IRA contributions, but you must have earned income. And you can keep contributing to the account after retirement.
The government, however, restricts the amount you can contribute. For 2021, the annual limit is $6,000 and $7,000 if you’re 50 years old or older. Per Roth IRA rules, higher earners may be restricted from contributing the full amount each year. And if you breach an earning threshold, you won’t be able to open a Roth account.
After turning 59.5 years old, you can make earning withdrawals, provided you’ve held the account for at least five years. Remember that tax-free withdrawals are only for original contributions. If your withdrawal includes additional money that you’ve earned through the account below five years, you will be taxed. Roth IRAs cannot be made into a joint account, but you and your spouse can jointly file under each (individual) account.
|NOTE: instead of creating a joint Roth IRA account, you can create a Spousal Roth IRA account if your spouse has no earned income. You can make contributions on their behalf.|
Roth IRA Eligibility and Limits on Contributions
Limits on contribution revolve around the amount of income you have. As the table below shows, higher earners face more restrictions when it comes to contributions.
|Filing Status||Modified Adjusted Gross Income (MAGI) for 2021||Maximum Annual Contribution|
|Single, Head of Household, or Married Filing Separately (didn’t live with spouse during the year)||$125,000||$6,000 ($7,000 if 50 or older)|
|$125,000 – $140,000||Reduced Contribution|
|$140,000||No Contribution Allowed|
|Married Filing Jointly or Qualifying Widow(er)||$198,000||$6,000 ($7,000 if 50 or older)|
|$198,000 – $208,000||Reduced Contribution|
|$208,000||No contribution allowed|
|Married Filing Separately (lived with spouse any time during the year)||$10,000||Contribution is reduced|
|$10,000 or more||No contribution allowed|
|NOTE: Employers’ plans sometimes allow for Roth contributions. Check with your employer to understand if they have a designated Roth account for employees.|
How to Open a Roth IRA
Nearly all investment companies and banks offer Roth IRAs. If your company offers such accounts, they probably could open a Roth IRA for you. Online brokers also offer Roth IRAs.
To open an account, prepare the necessary documents ahead of time to ease the process. Common requirements include:
- Driver’s license
- Social Security Number (SSN)
- Checking or savings account number
- Employer name and address
- Name, address, and SSN of your plan beneficiary (in case of death)
If you want to invest your Roth IRA money, you must create a portfolio. Roth IRA investment options include stocks, bonds, and mutual funds. If you’re not portfolio-savvy, you can typically choose from some off-the-shelf portfolios. Consulting a financial advisor at this stage would be wise.
When choosing among eligible companies, be ready to ask the following questions:
Do they insure the account?
The account must be insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC insures traditional and Roth IRAs up to $250,000.
Do all companies charge the same fees? What is the fee range?
Providers charge a monthly fee for maintaining a Roth IRA savings account. Expect to pay between $25.00 to $50.00 per year. This fee should be disclosed in the paperwork.
Do all companies offer the same investment options?
Check whether the companies offer the same types of assets. Some investments provide better tax sheltering. Your best choices are those that generate highly taxable income, no matter if they’re dividends or short-term capital gains. Assets that provide long-term appreciation are also great options, such as Roth IRA stocks.
Can eligible Roth IRA institutions set their own account requirements?
Remember to verify whether the institution has account requirements that deviate from what the government mandates. For instance, while you can have multiple Roth IRAs on various providers, your total contribution must not exceed the annual limit.
|Note: You can either set up a monthly contribution schedule or make a yearly contribution. But remember, the sooner you contribute, the sooner your money can grow.|
Ways to Fund a Roth IRA Account
All Roth IRA contributions are made in cash or by check. This means you cannot fund your account using assets or securities. Here are a few things you should remember when making contributions:
If you’re working for an employer, your wages, commissions, bonuses, and other payments are eligible contributions. Knowing how to read a W-2 form will give you a better idea about your compensation and which part of it is earned income. If you’re self-employed, your net earnings are also eligible contributions.
Spousal Roth IRA Contribution
You can make IRA contributions on behalf of a non-working spouse. For Roth IRA eligibility and limits refer to the table above.
You can transfer your Roth IRA to a new custodian, tax-free. The money should be transferred into another Roth IRA, not other types of accounts. You can either make a direct transfer or ask your current custodian to issue a check. You’re then responsible for depositing the money into a new Roth account within 60 days. Missing that deadline converts the withdrawal into a distribution of assets, which may be subject to Roth IRA taxes or penalties.
You can roll over your after-tax contributions to a Roth account without including earnings. There’s also no limit on the amount you can roll over into a Roth IRA from another retirement account, as long as they are after-tax contributions.
while you can’t contribute to a Roth account when you exceed limits, you can convert all or part of your traditional IRA to a Roth through a backdoor Roth IRA. Doing so, however, means you’ll owe taxes on the money you’ve withdrawn from the traditional IRA. If you do a backdoor Roth IRA, first know where to get a free tax consultation to understand if it’s better not to convert.
|NOTE: Distributions to multiple destinations at the same time are treated as a single distribution. You can roll over pre-tax amounts to a traditional IRA and your after-tax amounts to a Roth IRA.|
Let’s see in a few words how does a Roth IRA work:
|Roth IRAs let you contribute after-tax dollars and withdraw a distribution, tax-free.|
|Higher earners may be restricted or prohibited from contributing to Roth IRAs each year.|
|Nearly all investment companies and banks offer Roth IRAs, but you need to vet each company to know which one offers the best benefits and investment options.|
|If you’re employed, your wages, commissions, bonuses, and other payments for your services are eligible contributions.|
|If you’re self-employed, your net earnings are eligible contributions.|
Who Can Contribute to a Roth IRA?
Anyone who has an earned income can contribute to Roth IRA, as long as they fall below the earnings limit. Eligible income can come in many forms.
If you’re working for an employer, your salary, bonuses, and other forms of compensation are considered eligible earned income. And, if you’re self-employed, your net earnings are considered eligible. If you’re self-employed but run a business through a limited liability company (LLC), the LLC doesn’t pay income tax but distributes profits to you, making it an ideal tax minimization strategy. Your LLC can contribute to your Roth IRA, but the IRS will treat it as your personal contribution.
When you start a Roth IRA, remember that rental income, interest income, investment income, pension, stock dividends, and capital gains are not eligible contributions.
|NOTE: Money gained from divorce is also an eligible contribution, whether it’s alimony, child support, or settlement money.|
Roth IRA Distributions
How does a Roth IRA work in terms of distributions? You have to meet certain requirements to make qualified withdrawals or distributions.
Roth IRA qualified distributions
Qualified distributions allow you to avoid taxes, as well as an early withdrawal penalty fee. The requirements are:
- The account must be at least five years old.
- Distributions take place under the following situations: you’re 59.5 years old or older, you have a disability, distribution is made to your beneficiary after your death, up to $5,000 is used for childbirth or adoption.
Meeting the above requirements means you can withdraw your original contributions and earnings without facing a penalty fee.
If you don’t meet these requirements, you can still avoid taxes and penalties by withdrawing just your original contributions, leaving your earnings untouched.
Roth IRA Non-Qualified Distributions
Any Roth IRA earnings withdrawal that doesn’t meet the above requirements are considered non-qualified withdrawals, which are subject to taxes and a 10% early-distribution penalty fee. You may avoid the penalties if the fund is used for:
- Medical expenses
- Unreimbursed medical expenses
- Qualified higher-education expenses
- Childbirth or adoption
|NOTE: You can qualify as a first-time homebuyer—even if you’ve owned a house in the past—as long as you meet the IRS definition of a first-time homebuyer.|
Benefits of Having a Roth IRA Account
Because of their many unique characteristics, Roth IRAs are preferred by most people to traditional IRAs. Here are the key Roth IRA benefits you should capitalize on:
- A tax-free retirement income: when you withdraw a contribution at retirement, you owe no income tax.
- Access money for emergencies: as long as the distribution comes from your original contribution, emergency withdrawals are tax-free and done without a penalty fee.
- Age isn’t a dealbreaker: you can let your money remain in your account, so it can grow, tax-free.
- Tax-free inheritance distribution: distributions from an inherited Roth IRA are also tax-free.
- Most anyone can contribute: while there are limits to who can contribute, workarounds are possible.
Opening a Roth IRA offers plenty of impressive benefits if you meet requirements and don’t exceed limitations. You can withdraw money anytime, especially for emergencies. Original contribution withdrawals are tax-free, and you can allow your money to grow in the account, even after retirement. And passing down your Roth IRA to your beneficiaries isn’t complicated; it’s tax-free and easy to process. Overall, Roth accounts are a powerful alternative to traditional IRAs.
While your contributions definitely help, the power of compounding drives major growth. Any dividends or interest your account earns is added to your balance. This, of course, depends on how much your chosen investments grow. In the best scenario, your account can grow, even when you’re not able to contribute.
The best way to use a Roth IRA is to start early to maximize the power of compounding. Make your contributions at the beginning of the tax year. Avoid making earnings withdrawals for as long as possible, especially if you haven’t met the five-year rule and other requirements for tax-free withdrawals.
Roth IRAs earn money through compounding interests. If your account holds investments that yield high-interest earnings, then that interest is added to your balance. For example, if you contribute $6,000 each year for 10 years and the interest is 7%, then you’ll have earned $83,095 during that time.
To invest in a Roth IRA, open a Roth account with online brokers or banks. You can invest the money in assets or securities, choosing among stocks, bonds, mutual funds, and others. Then, add money over time to increase growth, such as by rolling over funds from another retirement account.
Roth IRAs allow you to make tax-free withdrawals after funding it with after-tax dollars, upon meeting certain conditions. The distributions are not tax-deductible, but earnings withdrawals are solely yours if you’ve been holding the account for at least five years and you’re at least 59.5 years old or older.