How Does a Roth IRA Work?

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You’re thinking about taking your hard-earned income and setting it aside so that it can grow tax-free until retirement. Awesome! This is a big step in your financial journey — and something that you should feel confident about doing.

If you’re thinking about opening a Roth IRA, you’ve come to the right place. Keep reading to determine whether a Roth IRA is an option that you should explore.

What is a Roth IRA?

A Roth IRA is a type of individual retirement account (IRA) funded with post-tax dollars that allows you to put money away for retirement while maximizing tax advantages. Assuming the account is at least five years old and you’re at least 59 ½ years old, you can make qualifying withdrawals out of your Roth IRA without paying taxes.

The Roth IRA was named after William Roth, a former Senator from Delaware. It was introduced in conjunction with the Taxpayer Relief Act of 1997.

Since then, Roth IRAs have become one of the most popular retirement vehicles for investors of all ages. The latest data suggests that of the households that contributed to an IRA in 2019, 44% contributed to Roth IRAs.

How a Roth IRA Works

The easiest way to explain how a Roth IRA works is to compare it to its close counterpart — the Traditional IRA.

Roth IRA vs Traditional IRA

Investors are sometimes confused about how a Roth IRA is different from a traditional IRA. A Roth IRA is similar to a traditional IRA, as both types of accounts enable you to grow your funds without paying income taxes to the IRS for several decades, depending on when you get started.

The main difference between a Roth IRA and a traditional IRA is the fact that Roths are funded by after-tax dollars while traditional IRAs are funded by pre-tax dollars. With a Roth IRA, there is no deduction in the year of the contribution. Contributions to a traditional IRA, however, are tax-deductible, which can help some investors lower their tax rate.

Depending on your income, it’s possible to avoid a higher tax bracket by contributing to a traditional IRA and taking a tax deduction. When you reach retirement age, however, your distributions are taxed like ordinary income. Meanwhile, Roth IRA distributions are tax-free and penalty-free, assuming you take them out after you turn 59 ½.

Example: Let’s say you have a taxable income of $60,000.

  • If you contribute $6,000 to a Roth IRA, your taxable income will still be $60,000 for that year (meaning you pay taxes on the $6,000 you contributed), but you will not pay taxes when you take that money out after age 59 ½.
  • If you contribute $6,000 to a Traditional IRA, your taxable income will be $54,000 ($60,000 – $6,000) for that year, and you pay taxes on the money you contributed once you take it out after age 70 ½.

This is an extremely simplified example, but, as you can see, you still have to pay taxes when using an IRA or a Roth IRA. The main difference is when you pay them. Some investors prefer to pay taxes up front and take their gains out tax-free in retirement. Other investors aim to reduce their taxable income during their highest-earning years and then pay their share of taxes once they reach retirement.

Opening a Roth IRA

Opening a Roth IRA is incredibly easy. All you have to do is open a brokerage account using a service like Charles Schwab, Fidelity, or E*TRADE.

There are roughly 3,600 brokers in the U.S. right now, giving you plenty of options to find one that aligns with your needs.

Brokers can vary depending on fee structure, the platform itself, and the tools and resources they offer.

Learn More:

Contributing to a Roth IRA

While contributing to a Roth IRA isn’t difficult, it’s important to understand your eligibility and contribution limits.

Income Limits and Roth IRA Eligibility

Depending on the type of IRA you choose, there are different rules. For example, traditional IRAs do not have any taxable income limitations. However, there are income limitations for Roth IRA contributions. According to the IRS rules for 2021:

  • A single filer is allowed to contribute to a Roth IRA if adjusted gross income (AGI) is less than $125,000.
  • Partial contributions are allowed for single filers for 2021 if your modified adjusted gross income exceeds $125,000 but is less than $140,000.
  • Those who are married filing jointly can make a full Roth IRA contribution if modified adjusted gross income is less than $198,000, or a partial contribution if modified AGI is less than $208,000.

Roth IRA Annual Contribution Limits

Just like there are rules governing when you need to take required minimum distributions (RMDs), there are also rules that specify how much you are allowed to contribute to an IRA.

For 2021, total the annual limit for all IRAs and Roth IRAs is $6,000. If you’re 50 or older, total contributions are a bit higher but cannot exceed $7,000.

This may not seem like a lot, if you are earning a sizable income. But there’s a reason all financial advisors will tell you to open an IRA: You can increase the size of your account considerably over time if you make strategic investments.

How to Invest Roth IRA Funds

Once you open a Roth IRA account through a stock broker, the next step is to fund your account. This can be easily achieved by linking your bank account to your brokerage account. You typically have to wait a couple of business days for the money to appear in your account before you can start investing.

Once your brokerage account is open, you can buy whatever securities you want. Here are some options to consider.

Index Funds

Index funds are portfolios of stocks or bonds that track the performance of a specific financial market.

For example, a common index fund is the Standard & Poor 500 Index (S&P 500), which tracks the overall S&P 500 — or the top 500 publicly-traded U.S. companies. You can also find index funds to track the Nasdaq Composite, the Dow Jones, and even indexes in specific sectors.

Index funds are great because they can provide broad market access for investors, allowing you to invest in many different companies with a single investment. They also tend to offer low fees.

When considering Roth IRAs, one of the best parts about index funds is that they offer solid, long-term growth. Index funds are designed to provide steady compound growth over time while also protecting investors from market volatility. Index funds aren’t impervious to market fluctuations, but they generally perform well over a period of several years.

Most index funds are passively managed, meaning that they are designed to track the performance of a particular market and do not require a hands-on investment approach from an account manager.

Mutual Funds

Mutual funds are similar to index funds, as they provide access to a broad range of securities.

The main difference between a mutual fund and an index fund is that a mutual fund is designed to beat specific benchmarks instead of tracking them. Mutual funds are usually actively managed, meaning that an account manager takes a list of companies and then modifies the fund to try and maximize returns. As such, mutual funds tend to come with a higher risk. However, they can offer greater gains.

One thing to consider when searching for mutual funds is the expense ratio, which determines how much of the fund goes toward managing it (and away from your pile of money). Mutual funds tend to come with higher fees than index funds. And it should be noted that active management doesn’t always lead to better returns. According to Barrons, just 29% of active U.S. stock fund managers beat their benchmarks after fees in 2019.

ETFs

An exchange-traded fund (ETF) is a collection of securities that track market indexes or commodities.

ETFs are also similar to index funds but they are bought and sold in a different way. They are traded on an exchange in the same way that stocks are sold. Since ETFs are bought through a broker, you have to pay a commission any time you make a trade, unless your broker offers free trades.

That said, ETFs also tend to have lower expense ratios compared to index funds.

TIP: When considering how to allocate your capital, it’s always important to consider fees.

Individual Stocks

In addition to buying baskets of securities through index funds, ETFs, and mutual funds, you can also buy individual stocks for a Roth IRA.

This is generally a riskier play. But the strategy could pay off if you make the right decisions. Generally speaking, investors should think long-term when buying stocks in a retirement account and look for solid companies that you believe will continue to thrive over the years.

That said, you won’t have to worry about paying capital gains on investment options when they are in a Roth IRA. In other words, you can sell stocks strategically to get ahead. Just keep in mind that it takes work to beat the market. If you take a gamble on a single stock, you’re probably going to lose. That’s why savvy investors like to start with a foundation of index funds before moving on to individual stocks.

FAQ

Below are answers to some of the most common questions I receive about Roth IRAs.

Do you have to pay taxes with a Roth IRA?

The short answer is yes — you have to pay taxes on all retirement plans.

The main difference is when you have to pay taxes. With a Roth IRA, you pay taxes up front allowing you to grow your income on a tax-deferred basis. Traditional IRAs, on the other hand, are funded with pre-tax dollars. Taxes are due when you take distributions.

When can I access my Roth IRA funds?

One of the top questions investors have regarding Roth IRAs and retirement accounts in general is about when they can access their money without penalty.

When investing in a Roth IRA, you can withdraw contributions (not gains) with no penalty at any age — which is a nice perk, to say the least. And when you reach the age of 59 ½, you can withdraw contributions and earnings with no penalty as long as the account has been open for at least five tax years.

This is different from a traditional IRA. With a traditional IRA, you can access your money at any time, technically. But if you haven’t reached retirement age, you have to pay a 10% penalty in addition to paying taxes on each withdrawal.

It’s also important to keep in mind that there are early withdrawal limitations for both types of accounts. With a Roth IRA, there are no mandatory withdrawal rules. With a traditional IRA, you are required to start making withdrawals once you turn 70 ½.

What is an IRA rollover?

A rollover involves transferring funds from one investment vehicle to another.

You are allowed to convert a Traditional IRA to a Roth IRA. However, converting a Traditional IRA to a Roth IRA triggers a taxable event.

Is a Roth IRA better than a traditional savings account?

It’s not possible to say that a Roth IRA is better than an FDIC-insured traditional savings account. It’s just a different type of investment vehicle. Savers are more cautious, and investors have more appetite for risk.

When planning for retirement, it’s a good idea to have a high-yield savings account (HYSA) that provides strong interest returns while also shielding you from market volatility. Most investors choose to use savings and investment accounts together as they plan for retirement.

Can you use a Roth IRA to pay for college?

Contributing money to a Roth IRA is one way that families choose to pay for higher education expenses. By maxing out your IRA on an annual basis, you can have an option to pay for tuition using tax-free money (by taking advantage of the Roth IRA Education Exception) while also maximizing your chances of getting more income from the Free Application for Student Aid (FAFSA).

The trick is to invest in certain types of accounts like IRAs that shelter money from colleges when it comes time to apply for federal aid.

Can you have more than one type of retirement account?

There is no restriction governing how many individual retirement accounts you are allowed to have. Just keep in mind that — no matter how many accounts you have — contribution limits still apply. As such, it’s possible to have a Roth IRA and a traditional IRA — and even several of each — but you won’t get to increase your contribution limit.

The Bottom Line

Making Roth IRA contributions can be a smart option for people planning for retirement. You’ll be able to leverage great tax benefits, enabling you to grow your money for decades without giving money to the IRS. Hooray!

Of course, Roth IRAs aren’t for every type of investor. There are some great advantages to using a traditional IRA for retirement savings planning with tax-free growth, too. If you’re still unsure, talk to a tax advisor to help you figure out the best option for your specific needs.

Here’s to making smart decisions on your path to financial independence! I’m rooting for you every step of the way.

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