What Do You Need to Know About Roth IRAs?

The Squeeze

• A Roth IRA is a type of individual retirement account you can contribute to with after-tax dollars in exchange for a tax break in retirement.
• Experts generally advise investing in a Roth IRA (instead of a Traditional IRA) early in your career, when your income likely puts you in a lower tax bracket than you may be in during retirement.
• For tax years 2021, 2020 and 2019, you can contribute up to $6,000 ($7,000 if you’re age 50 or older) to any and all IRAs in your name.

So, saving for retirement is complicated, right? 

Are you saving enough? Can you afford to save enough? Are you taking advantage of an employer match or just throwing free money out the window? And now you can’t stop hearing about Roth IRAs. Is this yet another savvy financial move you need to make to avoid working until you're 97 years old?

Stay calm. Deep breath. Here’s what you need to know. 

What Is a Roth IRA?

A Roth IRA is a type of individual retirement account, a savings vehicle you can open without an employer sponsor.

Congress established the Roth IRA with the Taxpayer Relief Act of 1997, naming it after Senator William Roth, who sponsored the legislation. 

Roth IRA vs. Traditional IRA vs. 401(k)

The main difference between a Roth retirement account and a traditional one is the way they’re taxed.

• Roth: Contributions to a Roth account aren’t tax-deductible — so you pay taxes on your retirement savings before you contribute. When you withdraw from the account in retirement, you don’t have to claim it as income for tax purposes. So you don’t pay taxes on your retirement income.
• Traditional: Contributions to a traditional account are tax-deductible or pre-tax. You don’t have to pay taxes on the amount you contribute for the year you contribute it. When you withdraw from the account in retirement, you have to claim it as income and pay taxes.

Roth IRAs have fewer restrictions than traditional IRAs in other ways, too, including:

• No required distributions. Traditional IRAs come with a required minimum distribution (RMD) amount you have to withdraw from the account once you reach age 72. You can keep money in a Roth IRA as long as you live. (Once you die, money from any retirement account is distributed to your beneficiaries.)
• Penalty-free early withdrawals. Five years after opening a Roth IRA, you can withdraw from it anytime without paying the tax penalties you face with early withdrawal from other retirement accounts. You could take distributions penalty-free even earlier in some circumstances, including if you have a disability or use the money to purchase a home or pay certain medical expenses.

The difference between an IRA and 401(k) is that a 401(k) has to be sponsored by an employer, so you can only use one if you have a job that offers it. Typically, you’ll move funds from one employer’s 401(k) plan to another (or into an IRA) if you move jobs. Anyone can open and contribute to an IRA through a financial institution; they’re not tied to your job.

Roth IRA Contribution Rules

The amount you contribute to a Roth IRA each year counts toward the combined contribution limit that applies to all IRA accounts you own. 

For 2021, 2020 and 2019, that combined limit is $6,000 (or $7,000 if you’re 50 years old or older). That means if you contribute $3,000 to a traditional IRA, you can only contribute up to $3,000 more to a Roth IRA.

IRA contributions don’t affect your 401(k) contribution limits. Those are counted separately. 

Who’s Eligible for a Roth IRA?

Anyone with earned income up to $140,000 per year can contribute to a Roth IRA (or a traditional IRA).

Earned income is any money you make working — for yourself or someone else. Suppose your only income comes from investments or other sources the IRS classifies as “unearned income,” like child support or alimony, Social Security or unemployment benefits. In that case, you can’t contribute that money to an IRA.

Contributing to or having access to a 401(k) through your employer doesn’t affect whether or not you can contribute to an IRA. The account types come with separate contribution limits that don’t affect each other.

Roth IRAs don’t come with an age limit, so someone earning income at any age can open one. Because it’s an investment account, your kids would have to open an IRA as a custodial account if they’re under 18 (or the age of majority in your state).

Roth IRAs do, however, come with income restrictions based on your filing status. As your income goes up after $125,000, the amount you can contribute to a Roth IRA goes down, all the way to $0 if you earn $140,000 or more. 

The income restriction isn’t a huge deal, though. Experts would generally advise delaying your tax costs at those income levels, anyway.

Pros & Cons of a Roth IRA

Are Roth IRAs a good idea? Here are the benefits and drawbacks to consider before opening one:

Pros

• No taxes on distributions. Pay no income taxes when you withdraw money from the account.
• No required minimum distributions. If you don’t need the money in retirement, you can keep in your Roth IRA to continue growing with interest as long as you live, leaving a nest egg for your beneficiaries to inherit.
• Penalty-free early withdrawal. A Roth IRA could be a way to build your savings for retirement with funds that are still accessible to you in case of a major need.

Cons

• Contributions aren’t tax-deductible. You’ll pay tax on your IRA money the year you contribute it to the account, so you won’t enjoy the tax savings now.
• You could lose money. Like any investment account — and don’t forget, retirement savings are investments — you risk losing the money you contribute to an IRA if the stock market goes down. Experts tend to advise that you can weather a downturn and recover any losses as long as you don’t plan to retire in the next three to five years — but gains on investments are never guaranteed.

Should You Invest in a Roth IRA?

Here’s the rub: Financial planners tend to advise a Roth IRA is a good idea if you expect your income in retirement to be higher than what you earn now — as in, pay taxes now while you’re in a low tax bracket.

That’s most likely to be the case when you’re young and early in your career but could apply if you’re making a career change or are just getting started on your professional journey at a later age.

And, of course, you don’t have a functioning crystal ball, so it’s impossible to say for sure what your income will do over the years and which tax bracket you’ll land in upon retirement.

Right now, Roth IRAs are a hot ticket for millennials because they likely haven’t hit peak income yet. That’s probably why you can’t stop hearing about them — the internet loves to talk to millennials.

Financial planners for Gen X savers would probably have been all over Roth IRAs for that generation a decade or so ago if investing in anything circa the mid-aughts wasn’t completely terrifying to everybody.