The two most common types of IRAs are traditional IRAs and Roth IRAs. Both offer smart ways to invest money for the future, but the Roth IRA in particular can offer distinct advantages to those who qualify. That said, many people don’t know exactly what a Roth IRA is, or how a Roth IRA works.
What Is a Roth IRA?
A Roth IRA is an investment account that lets individuals put away money for retirement. Unlike a 401(k) plan, which is only offered through an employer, it’s possible to open a Roth IRA directly with many financial institutions.
Roth IRA contributions are made with after-tax money, which means individuals can’t deduct contributions from income tax. But it also means individuals can withdraw funds tax-free in retirement. In contrast, a traditional IRA works in the opposite way: contributions are tax-deductible, but individuals must pay taxes on withdrawn funds during retirement.
Whereas most individuals with any amount of earned income can open an IRA account, Roth IRA accounts have more restrictive criteria. Individuals must make below a certain threshold. In 2021 the limit is $125,000 for single people (people earning more than $125,000 but less than $140,000 can contribute a reduced amount); for married people who file taxes jointly, the limit is $198,000 (or up to $208,000 to contribute a reduced amount).
When it comes to max IRA contributions, there’s no difference between how a Roth IRA works and how a traditional IRA works. For each type of plan, the regular contribution limit for 2021 is $6,000, with an additional $1,000 allowed in catch-up contributions for individuals over age 50.
Advantages of a Roth IRA
Depending on an individual’s income and circumstances, a Roth IRA has a number of advantages.
• No age restriction on contributions. With an IRA, individuals must stop making contributions at age 72. A Roth IRA works differently: Account holders can make contributions at any age as long as they have income for the year.
• Post-retirement withdrawals are tax-free. For individuals who think they’ll be in the same tax bracket or a higher one upon retirement — whether because of high earnings from a business, other investments, or continued work — a Roth IRA might be advantageous.
• Early withdrawal option. With a Roth IRA, an individual can generally withdraw the money they’ve contributed (but not any earnings) after a five-year holding period, without penalty. In contrast, withdrawals from a traditional IRA before age 59 ½ may be subject to 10% penalty.
• No required minimum withdrawal (RMD). Unlike IRAs, which require account holders to start withdrawing money after a certain age, Roth IRAs do not have RMDs. That means an individual can withdraw the money as needed, without fear of triggering a penalty.
Roth IRA Eligibility
Not everyone can contribute to a Roth IRA. In order to do so, you must fall below certain income limits, based on your adjusted gross income. Here’s what you need to know:
• If you’re single, you can contribute the full $6,000 to a Roth IRA if your MAGI is less than $125,000 and make a partial contribution if your MAGI is less than $140,000.
• If you’re married filing jointly, you must earn less than $198,000 to contribute the full amount and less than $208,000 to contribute a partial amount.
• If you’re married filing separately, you must earn less than $10,000 to contribute a partial amount.
If you earn less than the contribution limit, you can only put in up to the amount of money you made that year. And to have your contribution apply to a certain year for tax purposes, you must contribute by that year’s tax filing deadline in mid-April (no extensions).
Roth IRA Contribution Limits
As of 2021, the contribution limit for a Roth IRA is $6,000, with an additional $1,000 allowed in catch-up contributions for individuals over age 50. For single individuals who make between $125,000 and $140,000, as well as married individuals making $198,000 to $208,000 filing jointly, that limit is reduced.
The IRS offers instructions for figuring out what sort of reduced Roth IRA contribution limit a person can expect based on their adjusted gross income.
Since Roth IRAs are funded with after-tax income, contributions are not tax-deductible.
Roth IRA Withdrawal Rules
Since Roth IRA account holders have already paid tax on the money in their account, they are typically able to withdraw contributions at any age, without paying taxes or a 10% early withdrawal penalty.
The exception: Withdrawal penalties apply if you have had your account open for less than five years and are under the age of 59 ½.
When it comes to earnings, that money may be withdrawn prior to 59 ½ without paying a penalty or taxes (as long you’ve been actively making contributions for at least five years) in certain circumstances:
• For a first home. You can take out up to $10,000 to pay for buying, building, or rebuilding your first home.
• Disability. You can withdraw money if you have a disability.
• Death. Your heirs or estate can withdraw money if you die.
Additionally, you can avoid the penalty, although you still have to pay income taxes, if you withdraw earnings for:
• Medical expenses. Specifically, those that exceed 7.5% of your adjusted gross income.
• Medical insurance premiums. During a time in which you’re unemployed.
• Qualified higher education expenses.
Not only are the early withdrawal restrictions looser than with a traditional IRA, the post-retirement withdrawal restrictions are lesser, as well. Whereas account holders are required to start taking distribution of funds from their IRA after age 72, there is no pressure to take distribution from a Roth IRA at any age.
Roth IRA vs. Traditional IRA
There are certain things a Roth IRA and a traditional IRA have in common:
• Effective retirement savings plan: Though the plans differ in the tax benefits they offer, both are a smart way to save money for retirement.
• Not an employer-sponsored plan: Individuals can open either type of IRA through a financial institution.
• Maximum yearly contribution: $6,000, with an additional $1,000 allowed in catch-up contributions for individuals over age 50
There are also a number of differences between a Roth IRA and a traditional IRA:
• Roth IRA has income limits on eligibility. In 2021 the limit is $125,000 for single people (with reduced contributions for those earning between $125,000 and $140,000); for married people who file taxes jointly, the limit is $198,000 (with reduced contributions for those earning between $198,000 and $208,000).
• Roth IRA contributions are not tax-deductible. While there are no tax benefits on the front end, individuals can take distributions tax-free during retirement.
• Roth IRA has no RMD. Individuals can withdraw money when they want, without the age limit imposed by a traditional IRA.
• Roth IRA allows for penalty-free withdrawals before age 59 ½. While there are requirements, an account holder can typically withdraw contributions (if not necessarily earnings) before retirement.
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Is a Roth IRA Right for You?
How do you know whether you should contribute to a Roth IRA or a traditional IRA? This checklist might help you decide.
• You might want to open a Roth IRA if you don’t have access to an employer-sponsored 401k plan, or if you do have a 401(k) plan but you’ve already maxed out your contribution there.
• Because contributions are taxed immediately, rather than in retirement, using a Roth IRA can make sense if you are in a lower tax bracket or if you typically get a refund from the IRS. It may also make sense to open a Roth IRA if you expect your tax bracket to be higher in retirement than it is today.
• Individuals who are in the beginning of their careers and earning less might consider contributing to a Roth IRA now, since they might not qualify under the income limits later in life.
• A Roth IRA can be helpful if you think you’ll work past the traditional retirement age. That’s because you can keep contributing to a Roth IRA, but not to a traditional IRA, after turning 72.
A Roth IRA has many of the same benefits of a traditional IRA, with some unique aspects that can be attractive to some people saving for retirement. No RMDs, no age limit on contributions, tax-free withdrawals—a Roth IRA has a lot going for it.
That said, not everyone will qualify to open a Roth IRA. SoFi’s Roth IRA calculator lets individuals plug in income and other factors, to see which account they can contribute to and how much they can put in.
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