What Is a Roth IRA?

A Roth IRA is a tax-advantaged, retirement savings account that allows you to withdraw your savings tax-free. Established in 1997, it was named after William Roth, a former Delaware Senator. Roth IRAs are similar to traditional IRAs with biggest distinction between the two being how they’re taxed. Roth IRAs are funded with after-tax dollars; the contributions are not tax-deductible. But once you start withdrawing funds, the money is tax-free. Conversely, Traditional IRA deposits are generally made with pretax dollars; you usually get a tax deduction on your contribution and pay income tax when you withdraw the money from the account during retirement.

This and other key differences make Roth IRAs a better choice than traditional IRAs for some retirement savers.

Key Takeaways

  • A Roth IRA is a special retirement account where you pay taxes on money going into your account and then all future withdrawals are tax-free.
  • Roth IRAs are best when you think your taxes will be higher in retirement than they are right now.
  • You can't contribute to a Roth IRA if you make too much money. In 2019, for singles, it's $137,000 in annual income; for married couples, it is $203,000.
  • The amount you can contribute changes periodically. In 2019, $6,000 a year unless you are over 50 in which case, you can do up to $7,000.
  • Almost brokerage firms, both physical and online, offer a Roth IRA. So do most banks and investment companies.

How a Roth IRA Works

Similar to other qualified retirement plan accounts, the money invested within the Roth IRA grows tax-free. However, a Roth is less restrictive than other accounts in several ways. Contributions can continue to be made once the taxpayer is past the age of 70½, as long as he or she has earned income. The taxpayer can maintain the Roth IRA indefinitely; there is no required minimum distribution (RMD) during the account holder's lifetime, as there is with 401(k)s and traditional IRAs.

A Roth IRA can be funded from a number of sources:

  • Regular contributions
  • Spousal IRA contributions
  • Transfers
  • Rollover contributions
  • Conversions

All regular Roth IRA contributions must be made in cash (which includes checks); they can't be in the form of securities or assets. However, a variety of investment options exist within a Roth IRA, once the funds are contributed, including mutual funds, stocks, bonds, ETFs, CDs and money market funds.

The IRS limits how much can be deposited in any type of IRA, adjusting the amounts periodically. The contribution limits are the same for traditional and Roth IRAs.

$6,000

The maximum annual contribution an individual can make in 2019 to a Roth IRA. Those 50-years-old and up can contribute up to $7,000.

Opening a Roth IRA

A Roth IRA must be established with an institution that has received IRS approval to offer IRAs. These include banks, brokerage companies, federally insured credit unions, and savings and loan associations. Generally, individuals open IRAs with brokers.

A Roth IRA can be established at any time. However, contributions for a tax year must be made by the IRA owner’s tax-filing deadline, which is generally April 15 of the following year. Tax-filing extensions do not apply.

There are two basic documents that must be provided to the IRA owner when an IRA is established:

These provide an explanation of the rules and regulations under which the Roth IRA must operate, and establish an agreement between the IRA owner and the IRA custodians/trustee.

Not all financial institutions are created equal. Some IRA providers have an expansive list of investment options, while others are more restrictive. Almost every institution has a different fee structure for your Roth IRA, which can have a significant impact on your investment returns.

Your risk tolerance and investment preferences are going to play a role in choosing a Roth IRA provider. If you plan on being an active investor and making lots of trades, you want to find a provider that has lower trading costs. Certain providers even charge you an account inactivity fee if you leave your investments alone for too long. Some providers have more diverse stock or exchange-traded fund offerings than others; it all depends on the type of investments you want in your account.

Pay attention to the specific account requirements as well. Some providers have higher minimum account balances than others. If you plan on banking with the same institution, see if your Roth IRA account comes with additional banking products. If you're looking at opening a Roth at a bank or brokerage where you already have an account, see whether existing customers receive any IRA fee discounts.

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Roth IRA Vs. Traditional IRA

Are Roth IRAs Insured?

If your account is located at a bank, be aware IRAs fall under a different insurance category than conventional deposit accounts. Therefore, coverage for IRA accounts is less. The Federal Deposit Insurance Corporation (FDIC) still offers insurance protection up to $250,000 for traditional or Roth IRA accounts, but account balances are combined rather than viewed individually.

For example, if the same banking customer has a certificate of deposit held within a traditional IRA with a value of $200,000 and a Roth IRA held in a savings account with a value of $100,000 at the same institution, the account holder has $50,000 of vulnerable assets without FDIC coverage.

What Can You Contribute to a Roth IRA?

The IRS dictates not only how much money you can deposit in a Roth, but the type of money you can deposit. Basically, you can only contribute earned income to a Roth IRA.

For individuals working for an employer, compensation that is eligible to fund a Roth IRA includes wages, salaries, commissions, bonuses and other amounts paid to the individual for the services they perform. It's generally any amount shown in Box 1 of the individual's Form W-2. For a self-employed individual or a partner in a partnership, compensation is the individual’s net earnings from their business, less any deduction allowed for contributions made to retirement plans on the individual’s behalf and further reduced by 50% of the individual’s self-employment taxes.

Money related to divorce—alimony, child support, or in a settlement—can also be contributed.

So, what sort of funds aren't eligible? The list includes:

  • Rental income or other profits from property maintenance
  • Interest income
  • Pension or annuity income
  • Stock dividends and capital gains

You can never contribute more to your IRA than you earned in that tax year. And, as previously mentioned, you receive no tax deduction for the contribution—although you may be able to take a Saver's Tax Credit of 10% to 50% of the deposit, depending on your income and life situation.

Who's Eligible for a Roth IRA?

Anyone who has taxable income can contribute to a Roth IRA—as long as they meet certain requirements concerning filing status and modified adjusted gross income (MAGI). Those whose annual income is above a certain amount, which the IRS adjusts periodically, become ineligible to contribute. The chart below shows the figures for 2019.

Do You Qualify for a Roth?
Category Income Range for 2019
Married and filing a joint tax return At least $193,000, but less than $203,000 
Married, filing a separate tax return and lived with spouse at any time during the year More than zero, but less than $10,000
Single, head of household, or married filing separately without living with spouse at any time during the year At least $122,000, but less than $137,000 

These individuals must use a formula to determine the maximum amount they may contribute to a Roth IRA. An individual who earns less than the ranges shown for his or her appropriate category can contribute up to 100% of his or her compensation or the contribution limit, whichever is less. 

The Spousal Roth IRA

One way a couple can boost their contributions: the spousal Roth IRA. An individual may fund a Roth IRA on behalf of their married partner who earns little or no income. Spousal Roth IRA contributions are subject to the same rules and limits as regular Roth IRA contributions. The spousal Roth IRA must be held separately from the Roth IRA of the individual making the contribution, as Roth IRAs cannot be joint accounts.

For an individual to be eligible to make a spousal Roth IRA contribution, the following requirements must be met:

  • The couple must be married and file a joint tax return.
  • The individual making the spousal Roth IRA contribution must have eligible compensation.
  • The total contribution for both spouses must not exceed the taxable compensation reported on their joint tax return.
  • Contributions to one Roth IRA cannot exceed the contribution limits for one IRA (however, together the two accounts allow the family to double their annual savings).

Withdrawals: Qualified Distributions

At any time, you may withdraw contributions from your Roth IRA both tax- and penalty-free. If you take out only an amount equal to the sum you've put in, the distribution is not considered taxable income and is not subject to penalty, regardless of your age or how long it has been in the account. In IRS-speak, this is known as a qualified distribution.

However, there's a catch when it comes to withdrawing account earnings—any returns the account's generated. For distribution of account earnings to be qualified, it must occur at least five years after the Roth IRA owner established and funded his/her first Roth IRA, and the distribution must occur under at least one of the following conditions:

  • The Roth IRA holder is at least age 59½ when the distribution occurs.
  • The distributed assets are used toward the purchase—or to build or rebuild—a first home for the Roth IRA holder or a qualified family member (the IRA owner's spouse, a child of the IRA owner and/or of the IRA owner's spouse, a grandchild of the IRA owner and/or of their spouse, a parent or other ancestor of the IRA owner and/or of their spouse). This is limited to $10,000 per lifetime.
  • The distribution occurs after the Roth IRA holder becomes disabled.
  • The assets are distributed to the beneficiary of the Roth IRA holder after the Roth IRA holder's death.

The 5-Year Rule

Your withdrawals may be subject to taxes and/or a 10% penalty, depending on your age and whether you’ve met the 5-year rule. Here’s a quick rundown.

If you meet the 5-year rule:

  • Under 59½: Earnings are subject to taxes and penalties. You may be able to avoid taxes and penalties if you use the money for a first-time home purchase (a $ 10,000-lifetime limit applies), or if you have a permanent disability or you pass away (and your beneficiary takes the distribution). 
  • Age 59½ and older: No taxes or penalties. 

If you don’t meet the 5-year rule:

  • Under 59½: Earnings are subject to taxes and penalties. You may be able to avoid the penalty (but not the taxes) if you use the money for a first-time home purchase (a $10,000 lifetime limit applies), qualified education expenses, or unreimbursed medical expenses, or if you have a permanent disability or you pass away (and your beneficiary takes the distribution). 
  • 59½ and older: Earnings are subject to taxes but not penalties.

Roth withdrawals are made on a FIFO basis (first in, first out)—so any withdrawals made come from contributions first. Therefore, no earnings are considered touched until all contributions have been taken out first.

Withdrawals: Non-Qualified Distributions

A withdrawal of earnings that do not meet the above requirements is considered a non-qualified distribution and may be subject to income tax and/or a 10% early-distribution penalty. There may be exceptions, however, if the funds are used:

  • For unreimbursed medical expenses. If the distribution is used to pay unreimbursed medical expenses for amounts that exceed 10% of the individual's adjusted gross income (AGI) for the year of the distribution. (That 10% number applies to 2019; for 2018 it was 7.5% of the AGI.)
  • To pay medical insurance. If the individual has lost his or her job.
  • For qualified higher-education expenses. If the distribution goes toward qualified higher-education expenses of the Roth IRA owner and/or his or her dependents. These qualified education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution and must be used in the year of the withdrawal.

There is yet another loophole for earnings: If you withdraw only the amount of your contributions made within the current tax year—including any earnings on those contributions—they are treated as if they were never made. If you contribute $5,000 in the current year and those funds generate $500 in earnings, you can withdraw the full $5,500 tax-free and penalty-free if the distribution is taken before your tax filing due date.

Roth IRA vs. Traditional IRA

Whether or not a Roth IRA is more beneficial than a traditional IRA depends on the tax bracket of the filer, the expected tax rate at retirement, and personal preference.

Individuals who expect to be in a higher tax bracket once they retire may find the Roth IRA more advantageous since the total tax avoided in retirement will be greater than the income tax paid in the present. Therefore, younger and lower-income workers may benefit the most from the Roth IRA. Indeed, by beginning to save with an IRA early in life, investors make the most of the snowballing effect of compound interest: Your investment and its earnings are reinvested and generate more earnings, which are reinvested and so on.

Consider opening a Roth over a traditional IRA if you are more interested in tax-free income when you retire than in a tax deduction now when you contribute.

Of course, even if you expect to have a lower tax rate in retirement, you'll still enjoy a tax-free income stream from your Roth. Not the worst idea in the world.

Those who don't need their Roth IRA assets in retirement can leave the money to accrue indefinitely and pass the assets to heirs tax-free upon death. Even better, while the beneficiary must take distributions from an inherited IRA, they can stretch out tax deferral by taking distributions based on how long they are expected to live. Traditional IRA beneficiaries, on the other hand, do pay taxes on the distributions. Also, a spouse can roll over an inherited IRA into a new account and not have to begin taking distributions until age 70½.

Some open or convert to Roth IRAs because they fear an increase in taxes in the future, and this account allows them to lock in the current tax rates on the balance of their conversions. Executives and other highly compensated employees who are able to contribute to a Roth retirement plan through their employers [for example, a Roth 401(k)] can also roll these plans into Roth IRAs with no tax consequence and then escape having to take mandatory minimum distributions when they turn 70½. (For related reading, see "Best Roth IRAs of 2019")