What is a Roth IRA?

Even if your retirement is years down the line, it’s never too early to start planning. While you might be familiar with employer-sponsored retirement funds, like a 401(k), you could also consider an individual retirement account (IRA) as part of your overall plan. A Roth IRA is one type of individual retirement plan available to you.

But what is a Roth IRA, and how does it compare to a traditional IRA? Read on to learn about the benefits of this type of investment account.

Key takeaways

• A Roth IRA is a retirement savings account that brings you tax-free growth.
• A Roth IRA is funded with post-tax money, as opposed to a traditional IRA, which is funded with pre-tax money.
• There are income and contribution limits on Roth IRAs that limit who may benefit from one.

A Roth IRA is an IRA funded using money you’ve already paid taxes on. Because your contributions have already been taxed, you can withdraw the money tax free when you retire. 

Unlike with some other retirement accounts, Roth IRA contributions can’t be deducted from your taxes. But the major advantage of this type of account is that your contributions will experience tax-free growth and become tax-free income when you make withdrawals at age 59 1/2 or older.

This tax-free growth is one of the reasons why a Roth IRA may be an enticing retirement tool for younger earners. Since your income level may be lower early in your career, you might pay a lower tax rate on the money you contribute than you would when making withdrawals from a traditional IRA upon retirement.

Another benefit of a Roth IRA is that the contributions you make may be withdrawn without penalty—which can be handy if you suddenly need cash for a down payment or other major expense. The reason you don’t need to pay a penalty on this withdrawal is that you’ve already paid taxes on the contribution.

This penalty-free withdrawal only applies to your contribution amount, however. If you choose to withdraw any of the earnings you’ve made before you reach age 59 1/2, you’ll need to pay a penalty. For this reason, it may be wise to consult a tax professional if you’re considering withdrawing money from your Roth IRA before retirement.

Whether you’re eligible to contribute to a Roth IRA will depend on your income. Income limits can change from year to year and will be different depending on whether you file your taxes singly or jointly. However you file, the Roth IRA limit will be based on your modified adjusted gross income (MAGI).

Take a look at the income and contribution limits for 2022 below:

• If you’re filing singly, you must have a MAGI of $129,000 or less.
• If you’re filing jointly, you must have a MAGI of $204,000 or less.

There are also limits to how much you may contribute to a Roth IRA in a given year. And the annual contribution you make to your Roth IRA must be less than the earned income you claim on your tax return for that specific tax year.

For the 2022 tax year, the maximum allowed Roth IRA contribution is $6,000. If you are age 50 or older, you may contribute an extra $1,000 for a total contribution of $7,000 for the tax year. This extra $1,000 is known as a catch-up contribution and is designed to assist older savers who may be behind on their retirement planning.

These are the general contribution and income limits for Roth IRAs, but there are special circumstances that fall outside these guidelines. For example, single filers who earn more than $129,000 but less than $144,000 may still be able to contribute to a Roth IRA, but with a reduced contribution limit.

See the Roth IRA contribution limits for 2022 for a full breakdown of these limits and contributions.

The five-year rule

There’s also something called the five-year rule when it comes to Roth IRAs. In order to make tax-free withdrawals at retirement, five years need to have passed from the initial contribution you made to the account.

Roth IRAs come with both advantages and disadvantages that can affect your retirement plans.

Roth IRA pros

Here are some of the pros associated with a Roth IRA:

• It provides a tax-free income stream for retirement. 
• No required minimum distributions.
• Contributions can be withdrawn penalty free if you need them.
• Earnings grow tax free.
• Roth IRAs may be passed to a beneficiary, such as your child, if you pass away.

Roth IRA cons

Here are some things to keep in mind when it comes to a Roth IRA:

• Contribution limits are capped each year.
• There’s a 10% early withdrawal penalty on account earnings.
• There are strict income eligibility requirements.
• It’s not tax deductible.
• It may impact financial aid for your child’s college expenses because distributions are considered income.

There are many similarities between traditional IRAs and Roth IRAs, including the annual contribution limits. However, there are also some big differences between the two accounts you’ll want to be aware of.

A Roth IRA may be worth considering if you’re looking for a retirement plan with flexibility and the idea of a tax-free income stream is appealing to you. 

But Roth IRAs aren’t your only option when it comes to retirement savings. Learn more about other investment possibilities and how to start saving for retirement.