With a Roth IRA, you make contributions with after-tax dollars, so you can avoid paying taxes when you’re ready to withdraw the money. Once you reach the age of 59 and a half, you can also withdraw earnings without facing any type of tax penalty (as long as you’ve held the account for more than 5 years).
How Does a Roth IRA Work?
The majority of individuals open a Roth IRA through an investment company or brokerage agency, but you can also open an account directly with a bank, credit union, or other qualified financial institution. There are no minimum age requirements for opening a Roth IRA, but there are income and contribution limits. See the table below for more information about Roth IRA income and contribution limits.
Fortunately, you can choose to make Roth IRA contributions at any point throughout the year and up to the tax filing day of the following year. For example, you have until April 18, 2023, to make contributions for the 2022 tax year. There are a number of methods you can use to make Roth IRA contributions. The most common method is through regular cash contributions. However, you also can make contributions through transfers, rollovers, and conversions.
Typically, you’re also able to determine how you want your funds invested. For example, do you want to invest in mutual funds, stocks, bonds, certificates of deposit, money market funds, exchange-traded funds, or another eligible investment? If you work with a financial advisor, they can help you determine which investment options are suitable for your specific situation.
With a Roth IRA, you can withdraw your contributions tax-free at any time. However, you may face tax penalties if you withdraw any portion of your earnings in the account before you reach the age of 59 and a half or if you’re over 59 and a half but have not held the account for at least 5 years.
For example, let’s say that you’re 35 years old and you’ve made $3,000 in Roth IRA contributions annually for the last 7 years. You can withdraw a total of $21,000 ($3,000×7) at any time without paying taxes or incurring any tax penalty. However, if you want to withdraw any amount over your contributions of $21,000, you may face a 10% tax penalty. There are certain qualifying events, such as purchasing a home, paying for higher education, or becoming permanently disabled, that may help you avoid this tax penalty.
Before investing in a Roth IRA, it’s important to understand the benefits and disadvantages of this type of investment. These details can help you decide if this is the right investment opportunity for you.
Roth IRA Benefits
There are numerous benefits to investing in a Roth IRA, including:
After-Tax Contributions: Unlike traditional IRAs, Roth IRAs allow you to make after-tax contributions. This can be an ideal benefit if you anticipate being in a higher tax bracket later in life.
Tax-Free Growth: By making post-tax contributions to your Roth IRA, you can also enjoy tax-free growth. This means you don’t pay taxes on any earnings accrued in your account unless you withdraw the funds before you turn 59 and a half or if you’ve had your account for less than 5 years.
Tax-Free Withdrawal of Contributions: Since you’re paying taxes on the funds before making your contributions, you don’t have to pay taxes on withdrawals made after you turn 59 and a half years old.
Multiple Contributions: Fortunately, regulations allow you to contribute to both a Roth IRA and a 401k through your employer. While you still can’t exceed your maximum contribution limits, contributing to both accounts can expand your investment portfolio.
No Minimum Distributions: One of the top advantages of investing in a Roth IRA is that there are no minimum distribution requirements at any age. You can leave your money in your Roth IRA account for as long as you wish and even pass it on as an inheritance.
No Inheritance Tax for Roth IRA: A Roth IRA transferred through an inheritance also allows for tax-free withdrawals.
Roth IRA Disadvantages
Contributions Are Not Pre-Taxed: Many investors prefer the benefit of making pre-taxed contributions to their individual retirement accounts. This type of contribution isn’t an option with a Roth IRA. Only post-taxed contributions are acceptable.
Income and Contribution Limits: Like many retirement accounts, the IRS sets limits as to how much you can contribute to a Roth IRA.
5-Year Rule: You must have an established Roth IRA for at least 5 years before you can make a withdrawal without tax penalties. This is true even for those aged 59 and a half and older.
Tax Penalty for Early Withdrawals: While you can withdraw contributions to a Roth IRA at any time, you cannot withdraw any portion of the earnings until you reach the age of 59 and a half and have had an account for 5 years. Unless you have a qualifying exemption, you must pay a 10% tax penalty on any earnings you withdraw prior to reaching the age of 59 and a half.
What Are the Roth IRA Income Limits?
The IRS limits how much you can contribute to your Roth IRA in any given year. These limits are based on your tax filing status and yearly income. The table below provides information about these limits for 2022.
Tax filing status
Income for 2022
Maximum Roth IRA contribution allowed
Single, head of household, married filing separately (and did not live with spouse at any point through the year)
Less than $129,000
$6,000 or $7,000 if age 50 or over
$129,000 to $144,000
No contribution allowed
Married filing jointly, Qualified widow
Less than $204,000
$6,000 or $7,000 if aged 50 or over
$204,000 to $214,000
No contribution allowed
Married filing separately (did live together at some point through the year)
Less than $10,000
$10,000 or more
No contribution allowed
If your income exceeds the IRS limits, you may still be able to make Roth IRA contributions using a back-door method, referred to as conversion contributions. The Roth conversion process works by transferring funds from one account, such as a traditional IRA or 401k account, into a Roth IRA. Since there are no income restrictions on Roth conversions, investors who do not qualify for regular contributions may be able to establish a Roth IRA using this method.
However, it’s important to note the pro-rata rule, which states that taxation of IRA accounts when converted partially or fully to Roth accounts will be calculated proportionally to the fraction of after-tax vs. before-tax contributions. You do need to pay taxes on the amount transferred. This is because contributions made to a 401k or traditional IRA use pre-tax dollars. This strategy could lead to a hefty tax bill. It’s important to discuss these tax implications with a financial advisor before making this type of contribution.
Opening a Roth IRA
Opening a Roth IRA is a fairly easy process. Here’s a look at the 5-step process for opening a Roth IRA.
1. Check Your Eligibility
Since there are no age requirements for opening a Roth IRA, almost everyone is eligible. However, depending on your tax filing status and income level, you may be limited on how much you can contribute each year into a Roth IRA or if you can make any contributions at all. Before opening a Roth IRA, check the income limits in the table above to find out if you are eligible to make contributions to this type of account.
2. Select a Broker or Investment Firm
Once you’ve determined your eligibility, it’s time to select a broker or investment firm. You also can open a Roth IRA directly with a bank or credit union, but you may not receive the same level of financial advice. When comparing brokers and investment firms, be sure to read the fine print. Find out if it has any minimum deposit requirements or fees.
3. Complete the Application
The next step is to complete the Roth IRA application process. This process is similar to opening a checking account. You need to have your Social Security number along with proof of identification, such as your state-issued driver’s license. If you plan to make automatic deposits into your Roth IRA, be sure to have your bank account information ready. Additionally, you also need the contact information, including name, date of birth, and Social Security number, of the beneficiaries of your Roth IRA.
When opening your account, you will receive two important documents, including an IRA disclosure statement and an IRA adoption agreement and plan document. It’s crucial that you take the time to read both documents. They will explain the rules and regulations pertaining to your specific Roth IRA account.
4. Choose Your Investment Options
When opening a Roth IRA, you have the option of choosing where you want to invest these funds. For instance, you can choose to invest in mutual funds, money markets, stocks, bonds, ETFs, or certificates of deposit. Each investment type comes with its own advantages and disadvantages. The type of investment that’s right for you depends on several factors, including your risk tolerance and financial goals. It’s important to discuss your options with your financial advisor to determine which investment strategy is appropriate for your situation.
5. Fund Your Roth IRA Account
Now, you’re ready to fund your Roth IRA account. You can choose to manually make contributions to your account throughout the year or make automatic contributions. You can set up automatic payments through your bank account or work with your employer and set up a payroll deduction. Automatic contributions are a convenient option for managing your Roth IRA account. However, it’s important that you keep an eye on these contributions throughout the year to prevent investing more than your maximum limit.
How to Choose a Roth IRA Investment
It’s important to note that not all Roth IRAs are the same. In fact, there’s a wide range of Roth IRA options available, so you need to do a little research when choosing the right type for you. When comparing Roth IRA investment opportunities, there are several factors you should consider, including:
Minimum balance requirements
Customer service options
Financial advice services
Comparing these factors to your personal financial goals can help you choose the right Roth IRA investment broker for you.
How Much Do Roth IRAs Make a Year?
The goal of opening a Roth IRA is to watch your money grow and gain interest over time. The amount of money you can expect to earn per year with a Roth IRA varies significantly based on the amount of your contributions and your investment options. It’s helpful to speak to a financial advisor to better understand your earning potential with a Roth IRA investment.
Which Is Better, a 401k or a Roth IRA?
Fortunately, you don’t have to choose between a 401k and a Roth IRA. As long as you meet eligibility requirements and don’t exceed contribution limits, you can invest in both a 401k and a Roth IRA.
Roth IRA vs Traditional IRA
The main difference between a Roth IRA and a traditional IRA is the type of contributions you make. With a Roth IRA, you make contributions with after-tax funds. Since you pay taxes on money contributed to your Roth IRA, you don’t pay taxes when withdrawing the money later. In fact, if you wait until you are aged 59 and a half or older, you won’t pay taxes on the earnings you made through your IRA either. This is typically a good option for investors who think they will be in a higher tax bracket later in life.
On the other hand, you use pre-tax dollars when making contributions to a traditional IRA. Since the money isn’t taxed at the time it’s deposited, you need to pay taxes on the money when you withdraw it later. If you withdraw the money from a traditional IRA early, you will pay taxes on this amount as well as tax penalties, depending on your specific situation. This option is ideal for investors who believe they will be in a lower tax bracket during retirement than they are now.
Another major difference between these two investment types is that once you reach the age of 72, you’re subject to minimum distributions set by the government. With a Roth IRA, on the other hand, there are no such requirements. In fact, you can leave money in your Roth IRA for as long as you want. Additionally, inherited Roth IRAs offer tax-free withdrawals, whereas traditional IRAs do not.
Opening a Roth IRA can be a great investment opportunity for some people, depending on their current situation and future financial goals. Before opening a Roth IRA account, you may want to talk to a financial advisor to discuss your options.
If you’re ready to open a Roth IRA or you just want to explore your financial options, we’re here to help. Get started with Personal Capital by downloading our free, all-in-one financial planning tool.