What Is A Roth IRA, And How Does It Work?

September 19, 2021

What Is A Roth IRA

The Roth IRA is unique among other retirement accounts, in that it allows you to make annual contributions with after-tax dollars.

This means any money you contribute to your Roth IRA will not be taxed again when you are ready to withdraw the money at retirement.

What Is A Roth IRA?

Under the current tax code, every dollar that goes into a Roth IRA reduces your taxable income by one dollar for that year.

So if you contribute $5,000 to a Roth IRA this year, your taxable income will be reduced by $5,000.

A couple of key limitations apply though: non-deductible traditional IRAs cannot be converted into a Roth IRA and "super back-door" strategies don't qualify either.

So now that we've covered how a Roth IRA is different from other retirement accounts, let's look at some of the benefits of having one.

Why Should I Have A Roth IRA Instead Of A Traditional IRA?

Roth IRA Vs. Traditional IRA

This is actually a very good question and one that you should ask yourself before opening either type of account. There are many reasons to choose one over the other which we will cover below:

Traditional IRAs

Traditional IRAs allow your contributions to grow tax-deferred and withdrawals in retirement will be taxed as ordinary income (along with capital gains). This ensures that every dollar earned on your investments contributes to your taxable income today and will contribute again when you withdraw them later.

But if you think you'll be in a lower tax bracket during retirement than you are during working years, then you're in luck! A Roth IRA allows your contributions to grow tax-free and withdrawals aren't taxed as long as they meet certain requirements.

Another major benefit of a Traditional IRA is that you can avoid the early withdrawal penalty if: You use the money to pay for higher education expenses or You use the money when you file for bankruptcy protection.

Roth IRAs

A Roth IRA also has several advantages over a Traditional IRA:

Roth IRAs do not have required minimum distributions (unlike most other retirement accounts). So as long as you don't need the money, it will stay right where it is until you retire. There are no income limits on who can contribute.

Anyone, from teenagers to with low incomes, can open a Roth IRA and contribute a limited amount each year.

So if you have a part-time job, there's no better way to save for retirement than with a Roth IRA. You can use your Roth IRA money whenever you want.

If you take out a loan from your Roth IRA, the 10% early withdrawal penalty will not apply (unlike other retirement accounts). This may be the most important advantage since it allows you to access this money without losing a bunch of interest or getting hit with an early withdrawal penalty.

This is especially helpful during times of emergency.

How Much Can You Contribute?

The total annual contribution limit for Roth IRAs is $6,000 (or $7,000 if you're 50 or older).

However, there are some caveats to the rule: if your employer offers a Roth 401(k) plan and you contribute to it in addition to maxing out your IRA contributions, the maximum amount you can contribute in 2021 is $6,000.

The "earned income" requirement also includes taxable alimony and separate maintenance payments received by an individual during the year. It does not include nontaxable combat pay or other forms of nontaxable compensation such as Veterans Affairs (VA) benefits or welfare benefits.

Finally, even though the full annual IRA limit applies to each spouse individually, you can choose to apply your IRA contribution limit across your IRAs or just one of them. For example, if both you and your spouse are over 50 years old, you can contribute a total of $11,000 between the two of you ($13,000 if only one spouse is over 50).

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How Do I Make An Annual Contribution?

Roth IRA contributions can be made directly from your checking or savings account by completing a new account application with a brokerage firm that offers Roth IRAs (e.g., Vanguard). 

If you already have an existing traditional IRA with the same brokerage firm where you want to make the Roth IRA contribution, it's usually as easy as changing some beneficiary forms and investment selections.

When you make a Roth IRA contribution, the brokerage firm that holds your Roth IRA will send you an annual 1099-R form detailing how much money was deposited into your account.

The money will be considered "contributed" to your Roth IRA, not as income received by you, so the amount of the contribution should not impact your tax return or any calculations involving income taxes or earnings.

How Do I Withdraw Funds At Retirement?

If you are age 59 ½ or older at the time of withdrawal, any qualified distribution from your Roth IRA is completely tax-free.

However, if you are younger than 59 ½, non-qualified distributions may be subject to taxation and/or penalties (see more about this here ).

Early withdrawals include money that you take out before the Roth IRA has been opened for five years AND within the first five years of opening your account, any withdrawal on earnings.

At Distribution Time…What Do I Do With The Money?

If you take out money from your Roth IRA before you turn 59 ½, the distribution is considered non-qualified. When an early withdrawal is made, it's important to understand that this distribution will be added back to your taxable income for the year in which you receive it, unless you were already age 59½ or older when the funds were distributed.

If you decide not to reinvest or "recharacterize" your Roth IRA withdrawal, then the amount of the distribution will become part of your taxable income for that year. Even if you're under age 59 ½, remember that there are some exceptions allowing penalty-free early withdrawals such as using IRA money to purchase a first home (subject to certain restrictions).

How Much Will I Owe In Taxes?

The taxation of early withdrawals is subject to change, but as of 2021, the tax rate applied to your Roth IRA distribution will depend on the age at which you take out the money. 

For example, if you are under age 50 when you take out a nonqualified distribution from your Roth IRA, you would be taxed at 10%. If you are over age 59 ½ or older, then all distributions taken out or converted are qualified distributions, so they are all completely tax-free.

In Closing…

It's important to remember that Roth IRA contributions are not tax-deductible, but you can withdraw your contributions at any time without being taxed or facing penalties.

Also, Roth IRA conversion is only subject to taxation if the amount is withdrawn before age 59 ½. If you withdrew money from a traditional IRA and converted it to a Roth IRA, this is not considered an early withdrawal.

Lastly, be sure to check with your accountant or financial advisor about whether or not you should itemize deductions on Schedule A of your 1040 Form when filing income taxes each year.

The IRS offers some great calculators to help people determine estimated taxes owed depending on their individual circumstances.

About the author 

Jenna Lofton, the founder of StockHitter.com, has been actively trading stocks and investing for nearly 11 years.

She holds an MBA in Finance, and another in Business Administration, and lives in Staten Island, NY.

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