A Roth IRA account is a retirement savings account that offers tax-free growth and tax-free withdrawals.
How does a Roth IRA work?
A Roth IRA can suit almost anyone planning for retirement in the future, but the characteristics of this type of account are better suited for those who do not have access to an employer-sponsored 401(k) plan or a plan that offers a matching contribution. It can also be beneficial for those who can save more than the contribution limit allowed in a 401(k) plan.
There is no age at which account holders must start withdrawing funds from a Roth IRA. This makes the account a good option for those who wish to pass wealth onto their heirs or loved ones.
You cannot deduct contributions to a Roth account from your taxable income, but you may be able to claim a retirement savings credit based on your adjusted gross income. This credit helps boost savings among low- to moderate-income individuals. It helps them increase the amount they save and reduce taxes along the way.
You can contribute to a Roth IRA only if your modified adjusted gross income (MAGI) is below a certain threshold.
You can invest the money you add to a Roth IRA in assets of your choice, such as stocks, bonds, and mutual funds. The money you contribute to a Roth IRA will not reduce your taxable income, but the earnings will grow tax-free. In fact, you don’t even have to report the earnings to the Internal Revenue Service (IRS).
You also won’t have to pay taxes on much of the money you withdraw. This is true even after retirement and when you first use a Roth IRA for income. “Qualified distributions” that are tax-free are those taken after you reach age 59 and a half and have had the account for at least five years from the tax year you contributed to the Roth IRA. However, you may have to pay an additional 10% penalty if you withdraw the money outside of these times.
An example of a Roth IRA
Suppose you are 35 years old when you open a Roth IRA. You decide to add $6,000 (after tax) to the account each year. You earn a return of 6% each year.
You cannot deduct that $6,000 from your taxable income, but your account value will be $474,349 in 30 years, when you are 65 years old, at that rate of return. You won’t lose any of that due to taxes as long as you withdraw the money after age 59 and a half or for another IRS-qualified reason. Your net savings will be a full $474,349.
Note: There are certain exceptions provided by the IRS for the 10% penalty on early withdrawals. You will not face the 10% penalty if you are disabled, or if the amount is distributed to a beneficiary after your death, or for some other reasons specified in IRS Publication 590-B.
What is the contribution limit for a Roth IRA?
There are limits on the amount you can add to your Roth IRA each year. The maximum contribution to the account is the lesser of your taxable income for the year or $6,000, or $7,000 if you are age 50 or older, for the 2022 tax year. This is $6,500 or $7,500 respectively in 2023. Taxable income includes wages, salaries, and self-employment income, but excludes money you receive from interest or dividends.
You do not
You must make the full contribution all at once, even though the limit is set annually. You can make several smaller contributions as long as the total amount does not exceed the limit for the year. You can even contribute to both a traditional IRA and a Roth IRA as long as the total amount does not exceed the limit.
The amount you can add to a Roth IRA is restricted by your Modified Adjusted Gross Income (MAGI). You can contribute the maximum for 2022 if your MAGI is less than $204,000 for the year and you are married and file jointly. It is $129,000 if you are single, head of household, or married filing separately and did not live with your spouse at any time during the year. The limit drops to $10,000 if you lived with your spouse and filed separately.
Once you reach this threshold, the contribution amount begins to phase out until you can contribute nothing at all when MAGIs reach $214,000 for the year if you are married and file jointly, or $144,000 if you are single, head of household, or married filing separately and did not live with your spouse.
Note: Each Roth IRA contribution limit pertains to a specific calendar year. You can add money to a Roth IRA from January 1 of that year until the deadline for filing your tax return. You have until April 18, 2023, the tax return due date for your 2022 taxes, to make contributions for 2022.
You can contribute the full amount in 2023 if your MAGI is less than $218,000 for the year and you are married and file jointly. The amount you can contribute will start to phase out once you reach this threshold until you can contribute nothing at all when MAGI reaches $228,000 for the year.
These income limits drop to $138,000 to $153,000 in 2023 if you are single, meet the head of household financial criteria, or if you are married and file separately and did not live with your spouse at any time during the tax year. Single individuals can make the maximum contribution if their MAGI is less than $138,000 in 2023, less if their MAGI is less than $153,000, and nothing at all if their MAGI is $153,000 or more.
Alternatives to a Roth IRA
You may want to consider investing in a 401(k) plan first if your income is too high to contribute directly to a Roth IRA, or if you are not prepared to add a lot at all. Your employer may offer a matching contribution if they sponsor a 401(k) account, which can help grow your money faster. You can also add pre-tax dollars to a 401(k) account, which are funds not taxed as income.
The downside of a 401(k) plan is that you will have to pay taxes when it comes time to withdraw the money. Contributions to a Roth 401(k) allow you to avoid paying taxes on the distributions.
Traditional IRA accounts also accept pre-tax dollars from individuals at all income levels, up to the contribution limits allowed for Roth IRA accounts. The amount you can deduct may be limited if you have both an IRA and 401(k) through your job, and if your income exceeds certain thresholds.
Questions
Frequently Asked Questions (FAQs)
How can I open a Roth IRA account?
You can open a Roth IRA account at most banks or brokerage firms, either online or in person. Opening a Roth IRA account is a straightforward process, and there are usually people available to help you. Most accounts can be opened by simply filling out a few forms. You will need to have some things on hand, such as your social security number, as well as the social security numbers and addresses of anyone you wish to name as a beneficiary.
What is the “backdoor” strategy for a Roth IRA?
The backdoor strategy involves saving in a new Traditional IRA first, and then you can convert the savings to a Roth IRA. The catch here is that you will need to pay taxes on the amount converted because you are moving from a pre-tax account to a post-tax account.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and keep our content accurate, reliable, and trustworthy.
Internal Revenue Service (IRS). “Traditional and Roth IRAs.”
Internal Revenue Service (IRS). “Retirement Savings Contributions Credit (Saver’s Credit).”
Internal Revenue Service (IRS). “Publication 590-B (2021), Distributions From Individual Retirement Arrangements (IRAs).”
Internal Revenue Service (IRS). “Publication 590-B (2021), Distributions From Individual Retirement Arrangements (IRAs).”
Internal Revenue Service (IRS). “Retirement Topics – IRA Contribution Limits.”
Internal Revenue Service (IRS). “Publication 590-A (2021), Contributions to Individual Retirement Arrangements (IRAs).”
Internal Revenue Service (IRS). “Amount of Roth IRA Contributions That You Can Make for 2022.”
Internal Revenue Service
Source: https://www.thebalancemoney.com:443/what-is-a-roth-ira-2894492
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