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How a Roth IRA Works

Planning for your future and want to know more about this Roth IRA thing people keep talking about? Is it actually worth it? If the words “compound interest” don’t make you giddy yet, keep reading and you’ll soon see why the Roth IRA gets the personal finance folk of the country raving.

The Roth IRA is arguably one of the best retirement vehicles out there. The more you can understand the basics of this individual retirement account, the better you’ll be setting your future self up. Thanks, future self!

We’re going to talk through some Roth IRA basics in very clear terms, dropping any confusing terminology (which is tough to do when talking about such things). But we’re going to try! Let’s find out if a Roth IRA account would be in your best financial interest as you put together your retirement plan.

Roth IRA Basic Outline:

  1. How does a Roth IRA work?
  2. Why should I open one?
  3. Who’s eligible for a Roth?
  4. How do I make contributions?
  5. When and how do I get distributions from my Roth IRA?

How Does a Roth IRA Work?

A Roth IRA is an investment vehicle for retirement savings. You can think of it this way: it’s kind of like a file folder but instead of holding papers, it holds investments.

Now, for any investment that lives in this Roth IRA folder—it’s like that file folder gets this big label sticker on the front of it—and that gives everything in this folder some special tax treatments. You might have heard of a traditional IRA (and they sound kind of the same), but what sets Roth IRAs apart is this special tax treatment on the money made within that folder. Your investments grow tax-free, and you can withdraw your money tax-free when you retire.

In addition to the tax advantages, if you need to access your money before age 59½, you can withdraw your contributions (not to be confused with earnings!) without penalty. Of course, you probably don’t want to tap into your retirement money early (and we would say it’s a last-last-last resort), but the option is there if you need it.

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Why Should I Open a Roth IRA?

An example will probably work wonders here:

Let’s say you have an annual contribution of $1,000 after-tax income to your Roth IRA (below contribution limits, but just to keep it simple for now). And let’s say this $1,000 each year is invested in an S&P 500 Index fund or some low-cost exchange-traded funds (ETFs). If you do this from age 25 to 65, at an average annual return of 10%, you will end up with $527,000. Now, remember, you only contributed a total of $40,000 to your fund (40 years at $1,000 per year), so your investment grew $487,000. That whole $487,000 is tax free baby!

If you had simply invested that $1,000 in a normal mutual fund, where your earnings did not grow tax-free, and let’s say you have to pay capital gains at 20%, you would only have $291,000. So you can see that the Roth IRA, by being allowed to grow, and distribute its funds to you tax-free, saves you almost $200,000! That is sweet.

Who is Eligible for a Roth IRA?

You are eligible to open and contribute to a Roth IRA if you have earned income during the year. There’s no age limit to eligibility when you can open a Roth IRA (though if you’re a teen, you may need a custodial account). If your household income is too high and you’re in one of those upper echelons of the tax brackets, however, you can’t contribute at all.

For 2022, married couples filing together can contribute up to the $6,000 limit if their MAGI (their adjusted gross income) is less than $204,000, and single filers who make less than $129,000 can contribute the full amount to a Roth IRA. For those who make a few thousand dollars over the income limits, there is an option to fund a partial amount of the limit.

If you are in a higher tax bracket and earn more than the limits described above, a backdoor Roth IRA might be worth considering, and this is a completely legal route that will not send the IRS after you.

How Do I Make Roth IRA Contributions?

To make contributions to a Roth IRA, you’ll set up a Roth IRA account, offered through many financial institutions and brokerage firms. This is typically done on your own, rather than through a workplace like a 401k.

Then, you contribute after-tax dollars and pick funds to invest the money in. So that might look like setting up an automatic deposit from your checking or savings account every month (and super savers could max out the individual limit with a monthly contribution of $500/month), and then having the money automatically go into an low-cost index fund.

As we mentioned, there are IRA contributions limits to how much you can contribute to your Roth IRA each year. For the 2022 tax year, the limit is $6,000 per person. So, if you are married you could potentially contribute $12,000 in 2022 ($6,000 for you, $6,000 for your spouse). However, spousal contributions must meet the following requirements:

  • The couple must be married filing jointly on their tax return.
  • The person making the contribution must have eligible compensation.
  • The total contribution made for both spouses cannot exceed the taxable compensation of the couple.

Rental income, and interest and dividends are not eligible for contributions.

Also it’s good to note: these are not tax-deductible contributions in the year you contribute like another common retirement account like a 401k or a traditional IRA would be. But stay with us, there are still tax breaks down the line, because compounding will make up for this!

When and How Do I Get Distributions from My Roth IRA?

Alright, this gets a bit hairy, but it’s not really too bad. In order for a distribution to be tax and penalty free, it must be a qualified distribution. A qualified distribution must take place at least five years from the establishment of the Roth IRA and meet at least one of the following requirements:

  • You must be at least 59½ years old.
  • You’re making a qualified first home purchase for yourself, a child or a grandchild; up to $10,000 lifetime maximum withdrawal.
  • The funds are for higher education expenses for yourself, your spouse, a child, grandchildren or great-grandchildren.
  • Death or disability occurs.

If you don’t meet the requirements for a qualified withdrawal, you’ll have to pay income tax on your earnings plus a 10 percent early withdrawal penalty—which can add up to many more dollars than you might expect. Avoid unqualified withdrawals if at all possible. Certain exceptions apply, but for the sake of brevity (have I already lost my chance with that?) we won’t get into it.

Once you get good and old and gray, there is a thing called required minimum distributions (RMDs), where this account has to have money being taken out of it, but you don’t need to worry about that until you’re old and wrinkly.

Less Taxes Mean More Money in Retirement

The tax benefits of a Roth IRA can potentially save you hundreds of thousands of dollars that would have otherwise gone to the tax man. If you’re eligible to invest, then it’s definitely worth looking into opening a Roth IRA, especially if you’re in a lower tax bracket than you might be in the future. Don’t forget to set up a beneficiary on your account, and it’s never a bad idea to work with a fee-based financial advisor if you still want some one-on-one assistance.

The Roth IRA is a powerful investment vehicle when used properly. You can potentially save yourself hundreds of thousands of dollars you might otherwise have handed over to Uncle Sam. If you’re eligible to invest, then it’s definitely worth looking into opening a Roth IRA so you can start benefiting from the tax-free growth it offers.

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