Roth IRAs: What They Are and How They Work

Roth IRAs are individual retirement accounts (IRAs) that allow workers to save money for retirement using after-tax dollars. This means taxes are paid on the contributions before they are placed in the account. As a result, the funds are allowed to grow tax-free over time so that they can be withdrawn later on a tax-free basis. This tax strategy has made Roth IRAs a workshorse in modern retirement plans, especially for young savers.

A Roth IRA differs from a traditional IRA in terms of tax treatment. Taxes are paid before contributions are made to a Roth, but they're paid on a traditional IRA when the money is withdrawn. A Roth and traditional IRA also have different withdrawal requirements, access rules and other distinctions. In general, Roths are more flexible and offer advantages that have made them popular.

How are Roth IRAs funded?

A worker can fund a Roth IRA, or put assets in the account, from various sources, including regular contributions from the account owner, spousal IRA contributions, rollovers, conversions and transfers. A Roth also allows for the contributed funds to be placed in a wide variety of investments.

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Regular Roth contributions must be made in the form of cash rather than securities or other assets. However, not every income source can be used to fund a Roth. For example, some excluded sources include rental and interest income, dividends, capital gains on stocks and income from pensions or annuities.

Withdrawal rules and penalties

The IRS wants you to avoid spending Roth IRA funds for non-retirement purposes and has set up a number of barriers to easy withdrawal. So, before making a withdrawal from your Roth IRA, review the rules to avoid penalties and taxes.

You must distinguish between money you deposited in the account (contributions) versus money you earned from investment gains in the account (earnings). 

Contribution withdrawals. One of the biggest advantages of Roth IRAs over traditional IRAS? You can withdraw from the contributions you made to your Roth IRA at any time without taxes or penalties. But before you go raiding your Roth IRA, be very careul. Ensure you understand exactly how much you have contributed versus what you have earned in the account to avoid taxes and penalties.

Earnings withdrawals. You may have to pay taxes and penalties if you withdraw from the money you earned in your Roth IRA. You can generally withdraw earnings from a Roth IRA without penalty if you meet certain conditions. These are called qualified withdrawals. However, you will face a 10% early withdrawal penalty and sometimes taxes for violating these conditions.

Qualified withdrawals. For withdrawals of the earnings made on contributions to be considered qualified distributions, they must occur at least five years after the account was established and funded. Additionally, one of these conditions must also be met: the Roth holder must be at least age 59½ or disabled, the distribution must be used to buy or build a first home for the holder or a qualified family member, or the money is being distributed to the holder's beneficiary upon their death.

For unqualified or early distributions, a penalty can be avoided if the money is used for medical expenses or insurance, childbirth or adoption, or qualified higher education expenses.  This list is not exhaustive.

The rules on qualified distributions (withdrawals) are complex. If in doubt, refer to the IRS's Roth IRA guidance or ask a financial adviser for help.

Roth contribution limits

Pay attention to Roth contribution limits, which the IRS may raise yearly.

Maximum contribution. For 2024 and 2025, the maximum someone can contribute to a Roth IRA is $7,000 a year, although you can't contribute more than your earned income in any tax year.

Catch-up contributions. Those age 50 or older can also make catch-up contributions of an additional $1,000 per year, meaning they can contribute up to $8,000 total to all their IRAs.

All IRAs count. The maximum total of $7,000 (or the catch-up maximum of $8,000, if used) is shared across all IRAs, including traditional IRAs. So if you contribute $4,000 to a traditional IRA and you are under age 50, you can't contribute more than $3,000 to a Roth IRA in the same year, so your total invested is the maximum of $7,000 for those under 50.

Eligibility and income phaseouts. Not everyone is eligible to contribute to a Roth. Investors must have earned income in the tax year they want to contribute. They will also be ineligible to contribute if their modified adjusted gross income (MAGI) rises above a certain amount, known as an income phaseout.

In 2024, individual investors must earn less than $146,000 to contribute the full amount to a Roth and less than $161,000 to be eligible to contribute part of it. For married taxpayers filing jointly and living with their spouse, these numbers rise to $230,000 for the full amount and $240,000 for a partial contribution.

These limits increase in 2025 when individuals must earn less than $165,000 to make a partial contribution and $150,000 to contribute the full amount. Married couples filing jointly must earn less than $246,000 to make a partial contribution and less than $236,000 to contriubte the full amount.

Most financial institutions also have their own set of requirements for Roths, like varying minimum required balances. Some firms might charge an inactivity fee on accounts that are left alone for too long.

Finally, investors are always advised to do their due diligence when selecting a financial institution to manage their Roth or other retirement accounts.

Are you too old for a Roth IRA?

As with many retirement planning decisions, the answer here is "it depends." With a Roth IRA, you are making the gamble on tax rates today versus tomorrow, and the amount that your invested money will grow. Young workers have a built-in advantage when investing in a Roth IRA because their investment will grow tax-free over a long period of time, likely surpassing the amount they would have saved by taking the up-front tax benefit of a traditional IRA.

If you currently are in a high tax bracket and need some tax relief, or you think you will be in a lower tax bracket as you near retirement, then a traditional IRA may be for you.

However, Roth IRAs are more flexible than traditional IRAs, so there are cases when older workers might want to opt for a Roth.

Tax diversification. If most of your retirement funds are before-tax vehicles like traditional 401(k)s or IRAs, then a Roth IRA could help offset some of the tax burden when it comes time to spend down your nest egg.

No RMDs. During the lifetime of the original owner of a Roth IRA, there are no required minimum distributions (RMDs). RMDs require you to withdraw a certain amount from a traditional IRA or 401(k) account, generally starting at age 73. So, a Roth IRA can help with tax planning and allow for long-term growth.

Of course, if you need more detailed information, it's best to seek guidance from a qualified financial adviser or tax professional.

Better for your heirs. Roth IRAs can be an effective way to leave money to your heirs as they may access funds without owing taxes. As such, a Roth IRA can be an important part of your estate plan.

Roth IRA investment options

An IRA offers a wider array of investment options than an employer sponsored plan like a 401(k). Additionally, the owner can keep and contribute to their Roth IRA indefinitely because there are no required minimum distributions like there are with traditional IRAs and 401(k)s.

As with any retirement account, you should include a diverse mix of investments with varied risk profiles, tailored to your investment time horizon. Your Roth IRA may include a mix of mutual funds, ETFs, stocks, bonds, CDs and annuities, as well as target-date funds.

Prohibited investment vehicles include life insurance, collectibles, art and personal real estate. A few other sophisticated investments are also not allowed. 

What is a self-directed Roth IRA?

A self-directed Roth IRA offers access to the largest number of investment options compared to other types of Roths, although not every firm that offers IRAs may offer self-directed Roth IRAs.

With a self-directed Roth, the investor, rather than the financial institution that manages the account, chooses how the funds will be invested. Additional investment options include gold, cryptocurrency, real estate, partnerships and even a franchise business. However, not all financial institutions offer every investment option, so investors may want to keep that in mind when selecting a firm to manage their Roth. 

These type of IRAs are risky and not suited to most investors. For more, see the reasons why you should consider avoiding a self-directed Roth IRA.

How to open a Roth IRA

It's not difficult to open a Roth IRA; you just need to follow five simple steps. You may generally contribute up until April 15th of the year after the tax year you are funding. Experts recommend contributing as early as possible for the greatest tax-free growth.

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