What Is a Roth IRA and How Does It Work? (2024)

If you’re searching for a way to save for retirement and avoid a nasty tax bite in the future, a Roth IRA could be the answer. Roth IRAs are simpler than the original flavor of individual retirement accounts, known as traditional IRAs, because they are funded with post-tax dollars.

Both accounts shield your investment growth from taxes. But with a traditional IRA, the bill eventually comes due. With a Roth IRA, you won’t have to pay any additional taxes when you take out your contributions and you can avoid paying taxes on your earnings if you meet certain conditions, such as waiting to withdraw earnings until age 59 and a half or using them to buy your first house.

“Roth IRAs are a fantastic vehicle for saving for retirement and managing your tax liability in the future,” says David Edmisten, a financial planner in Prescott, Ariz., who advises early retirees. Plus, all the tax benefits of a Roth IRA transfer to the person who inherits the account, making it a great tool for gifting wealth to children or grandchildren.

And while the Internal Revenue Service doesn’t let you make direct contributions to a Roth IRA if your income exceeds $161,000 (if you’re single) or $240,000 (if you’re married filing jointly), there is a perfectly legal loophole that gives access to even the highest earners.

Here’s what you need to know about Roth IRAs, from eligibility requirements to tax considerations.

How does a Roth IRA work?

Roth IRAs are investment accounts you open through a brokerage or robo advisor that let you invest in stocks, bonds, mutual funds, ETFs, CDs and real-estate investment trusts.

It’s like a regular investment account, except that your earnings are sheltered from capital-gains taxes and income taxes. In exchange for the tax shield, you generally can’t withdraw your investment earnings from a Roth IRA until retirement (we’ll discuss the exceptions later).

But if you never want to withdraw money, that’s fine too. Withdrawals aren’t mandated like they are in other retirement accounts. This helps you manage your tax bill in your golden years, and keeps your investments growing.“A Roth IRA offers investors a lot of flexibility which, in my opinion, is its biggest benefit,” says Eric Presogna, a financial planner in Erie, Penn.

How is a Roth IRA different from a traditional IRA and from a 401(k)?

Tax treatment is the biggest difference between Roth IRAs and other retirement accounts. You may be able to claim a tax deduction for your contributions to a traditional IRA, which lowers your income and can lead to a smaller tax bill. But when you take money out of the account in retirement, you pay those taxes you avoided earlier. The same goes for a 401(k), except it is sponsored by your employer.

Roth IRAs—and Roth 401(k)s—flip the script. Instead of getting a tax break when you put money into the account, there’s no tax bite when you take money out. “If you are comfortable with volatility, you can really swing for the fences in your Roth IRA, and if you hit a home run you don’t have to share any of your winnings with the government,” says Nick Cantrell, a Massachusetts-based financial planner.

What’s more, Roth IRAs do away with one of the most frustrating features of traditional IRAs and 401(k)s: mandatory withdrawals. In those other retirement accounts, you’re forced to start taking money out once you turn 73 (75 starting in 2033). That’s not so with Roth IRAs, though.Known as RMDs, for required minimum distributions, mandated withdrawals are calculated based on your age and the balance of your account, and are generally taxed. No RMDs, combined with tax-free growth on your investments, means Roth IRAs offer uninterrupted compounding for as long as you live.

What are Roth IRA contributions limits for 2024?

You need to have earned income, such as wages, salaries or tips, to put money in an IRA of any sort. In 2024, you can deposit up to $7,000 in your IRAs. If you’re 50 or older, you can deposit an extra $1,000 in “catch-up” contributions—so, a maximum of $8,000 for the year. If your taxable income is lower than these thresholds, then that becomes your maximum contribution limit.

An important note: The annual limits apply to traditional and Roth IRAs, in aggregate—meaning you can’t add more than the allowed amount to your traditional and Roth IRAs combined.There may be consequences if you add too much to your IRAs and don’t withdraw the excess amount, including investment profit, before your next tax return is due. You’ll incur a 6% tax on the amount for each year excess contributions and earnings remain in your account.

Who can contribute to a Roth IRA?

In general, high earners are shut out of contributing directly to Roth IRAs. (Good news: there’s a workaround that we’ll cover below.)

Here are the income thresholds for single and married tax filers in 2024:

Note that even if you’re not eligible to make a contribution to a Roth IRA this year, you can still access previous contributions in your account and adjust your portfolio or make withdrawals.

What is a backdoor Roth IRA?

High-income workers can use the “backdoor Roth” strategy to get money into a Roth IRA. It requires making nondeductible contributions to a traditional IRA—anyone with earned income can do this—and then transferring that balance to a Roth IRA in a process known as a rollover.

With this type of rollover, you’re simply changing the type of container that holds your post-tax funds. And the container is important.

If you continued making nondeductible contributions to a traditional IRA, withdrawals of your investment earnings would be taxable, even after you meet the age and time requirements. By moving your money to a Roth IRA, you avoid those taxes, as well as mandatory withdrawals in your 70s.

The backdoor Roth is a perfectly legal loophole, experts say, but you have to act quickly to make the most of it. As a high earner, you don’t get an upfront tax deduction in the traditional IRA, so you won’t owe taxes on the contributions you transfer. If your investments have time to grow in the traditional IRA, you will owe a tax on those earnings when they are transferred to the Roth.

What is a Roth conversion?

A conversion happens when you move money—either pretax contributions or earnings—from a pre-tax retirement account to a post-tax Roth IRA. Put simply, you pay a one-time tax on your investments now so you don’t have to later.

Cantrell says conversions are underused. If you have the bulk of your nest egg in pretax accounts, such as a traditional IRA or 401(k), a well-timed conversion can save you a lot on taxes in the long run.

“We have many clients who take unpaid sabbaticals or time off between jobs,” says Zach Teutsch, a financial advisor in Washington, D.C. Those lower income years are often a good time to do conversions, he says.

There are two ways to do a Roth conversion. The financial institution that holds your traditional IRA or 401(k) can either send you a check to transfer the funds to a new account yourself, or they can do it for you. You can avoid accidental tax consequences by opting for the second choice, known as a trustee-to-trustee transfer.

How to open a Roth IRA

The first step is choosing the type of financial institution you want to work with. You can open a Roth IRA through a stock brokerage, as well as through a robo advisor. Some places require a minimum deposit to open an account, but most don’t.

Through an online brokerage, such as Fidelity or Vanguard, you can find professionally managed or self-directed IRAs. Managed accounts charge a fee on top of the expense ratio you pay to invest in mutual funds or ETFs, but often come with personalized investment advice and other benefits.

A robo advisor will give you more of a hands-off investment experience, where you provide information about your age and goals and get a portfolio made up of low-fee funds. Many big-name brokerages also have robo advisor platforms.

Like any investment account, Roth IRAs are portable. If you decide to move your account to a different financial institution down the road, you can do so without incurring penalties or taxes.

How to fund a Roth IRA

A Roth IRA typically needs to be funded before you can start choosing investments. Most institutions accept electronic transfers if you’re contributing cash.

If you want to roll over the balance of an existing traditional IRA, 401(k) or other employer-sponsored retirement account to a Roth IRA, you’ll have to follow specific rules outlined by the IRS. (Starting this year, owners of 529 plans can also roll over some unused funds to a Roth IRA.)

How to withdraw money from a Roth IRA

The portion of a Roth IRA withdrawal that is attributable to investment growth is treated differently than your contributions. Depending on when you take out the money, it may be subject to taxes and/or a penalty.

Contributions

The first thing to know about Roth IRA withdrawals is that money you contribute after paying taxes is always completely accessible. If the balance of your Roth IRA is $12,000, for example, and $10,000 of that came from your pocket, you can withdraw $10,000 at any time without triggering penalties or taxes.

However, financial planners don’t advise dipping into your contributions early, especially if you’re using the money to pay for nonemergencies It can disrupt the growth of your account and may even cause you to sell holdings when stock values are down.

Qualified distributions

A qualified distribution from a Roth IRA is when you withdraw investment earnings and don’t have to pay income taxes or a penalty. To be qualified, it has to meet two conditions.

First, the withdrawal must take place after you have owned the account for at least five years. (Technically, the five-year period starts on the first day of the year in which you made your first contribution or conversion to the account.)

Second, you must be making the withdrawal under one of these circ*mstances:

• You’re 59 and a half or older
• You’re a first-time home buyer (up to $10,000 in withdrawals)
• You’re disabled
• You’re the beneficiary of a Roth IRA owner who died.

Nonqualified distributions

A nonqualified distribution from a Roth IRA—also known as an early withdrawal—is when you take out investment earnings without meeting the five-year ownership rule and at least one of the conditions mentioned above. The withdrawal is usually subject to income taxes at your personal tax rate and a 10% penalty.

You can avoid the penalty, but not the income taxes, if the distribution is used for any of the following:

• Health insurance premiums while you were unemployed
• Medical expenses not covered by insurance (over 7.5% of your adjusted gross income)
• Expenses related to a permanent disability

• Qualified education expenses for you, your spouse or your child, up to $10,000
• Qualified expenses related to birth or adoption, up to $5,000
• A series of regular, annual payments calculated per IRS rules

Who might benefit from a Roth IRA?

Financial planners often suggest using both Roth IRAs and pre-tax accounts, including traditional IRAs, to manage your current tax burden and create income flexibility in retirement.

“Roth IRAs are especially advantageous for people contributing at times in their life when their tax rate is lower than it will be in the future,” Teutsch says. These people—who typically skew younger—aren’t in need of a tax break now, but they may be worried about reducing their exposure to higher taxes down the line when they’re pulling in more income or if tax rates go up.

Lastly, many experts say Roth IRAs are a smart way to transfer wealth to the next generation. Non-spouses who inherit them generally have 10 years to empty the account and don’t have to pay taxes on the money taken out; spouses have even more options. “They are a much better asset to inherit than an IRA,” says Cantrell.

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