- A Roth IRA is a tax-advantaged retirement account that allows you to invest with after-tax money and then withdraw funds tax-free during retirement.
- Unlike a 401(k), a Roth IRA is an individually managed retirement plan and has a contribution limit of $6,000 per year.
- Roth IRAs have income limits, which can prevent high-income earners from contributing—but a Roth conversion could help.
- Roth IRAs are suited to investors who feel they’ll be in a higher tax bracket during retirement, since they can pay the taxes now while their rate is lower.
You’ve probably heard that you should be saving as much as possible for retirement but may be wondering how to best maximize those dollars. While the 401(k) plan is a popular retirement savings tool that’s offered to many workers, it’s not the only investment option available.
Another popular tool to help you save for retirement is the Roth IRA (individual retirement account), which allows you to invest and grow your funds tax-deferred, then withdraw them tax-free during retirement. And, it's become a popular investment vehicle. “A Roth IRA is literally the best plan for long-term saving on taxes if you’re young enough to let it grow for decades,” says Karen Lee, a Certified Financial Planner and the founder of Karen Lee and Associates.
Are you wondering whether a Roth IRA is right for you? Find out how it works, how it differs from other retirement accounts, and the pros and cons to decide if it could fit into your retirement plans.
Inside this article
What is a Roth IRA and how does it work?
A Roth IRA allows your after-tax contributions to grow tax-free, and there are specific rules associated with this type of retirement savings account.
Roth IRA Contribution Rules
The IRS sets limits on who can use these accounts. In general, you can contribute the full $6,000 to a Roth IRA if you have an individual income of less than $129,000 or a joint income of less than $204,000. If you earn between $129,000 and $144,000 (or between $204,000 and $214,000 for married couples), you can contribute a reduced amount to your Roth IRA. Finally, if you exceed an individual income of $144,000 or a joint income of $214,000, you won’t be able to contribute to a Roth IRA at all.
There is one exception to the Roth IRA income limits through what’s known as a Roth conversion. Using a Roth conversion, you can move money from a traditional IRA to a Roth IRA, regardless of your income. Higher-income investors can use this strategy to take advantage of the benefits of a Roth IRA. There's no limit on the amount that can be converted to a Roth IRA. But keep in mind that you will pay taxes on the funds converted from pre-tax to Roth.
Roth IRA Distribution Rules
Roth IRA distributions have some unique features that other tax-advantaged retirement accounts don’t have.
First, because you’ve already paid taxes on the money you contribute to a Roth IRA, you can withdraw those funds at any time. As long as you don’t withdraw any of your earnings, you won’t pay taxes or penalties on those distributions.
When it comes to withdrawing your earnings from a Roth IRA, you can withdraw funds without taxes or penalties if it’s been at least five years since the first tax year in which a contribution was made to the Roth IRA, and one of the following is true:
You’ve reached the age of 59½.
You have a disability.
The withdrawal is being made as a part of your estate after your death.
You’re withdrawing up to $10,000 for the purchase of your first home.
If you withdraw funds from your Roth IRA before you’re allowed to, you’ll pay a 10% penalty tax on those early distributions.
Unlike other retirement accounts, a Roth IRA doesn’t have required minimum distributions (RMDs), meaning you don't have to start withdrawing money at a certain age. This rule is different from similar, tax-advantaged accounts that require distributions starting at age 72.
Pros and cons of a Roth IRA
Roth IRAs have some serious advantages, which is why they’ve become so popular in recent decades. However, they also have some important disadvantages you should understand.
Long-term tax benefits: Once you contribute after-tax money to your Roth IRA, the funds grow tax-free in the account, and you can withdraw them tax-free during retirement. You’ll get to keep a greater share of your investment earnings.
Easier to access funds than with a traditional IRA: Because you’ve already paid taxes on your Roth IRA contributions, you’re allowed to withdraw them (but not your earnings) at any time without paying taxes or penalties if your account has been opened for more than five years.
Roth conversions: Using a Roth conversion, anyone can take advantage of a Roth IRA, regardless of whether they’re over the income limit or have already met the contribution limit in their traditional IRA.
No required minimum distributions: Unlike other tax-advantaged retirement accounts, Roth IRAs don’t have required minimum distributions, meaning you can leave your money in your account to grow as long as you want.
Income limits: The IRS sets income limits on who can contribute to a Roth IRA. The only way for high-income earners to take advantage of these accounts is through a Roth conversion, which can be complicated.
Low contribution limits: The maximum amount you can contribute to a Roth IRA each year is $6,000 (plus $1,000 if you are over 50). This limit may be low as your sole retirement savings account if you don’t have access to an employer-sponsored retirement plan or if you’re working toward early retirement.
No upfront tax advantage: Unlike a 401(k) plan or traditional IRA, a Roth IRA doesn’t have any upfront tax advantages. You can’t reduce your taxable income in the year you make the contributions, which can be a disadvantage for investors in higher tax brackets.
Roth IRA vs. 401(k)
While both the 401(k) plan and Roth IRA have some serious tax advantages, they also have some critical differences.
The primary difference between a 401(k) plan and a Roth IRA is how it's administered. A 401(k) is a retirement plan that’s offered by an employer. A Roth IRA, on the other hand, is an individual account that you open and manage on your own. Because 401(k) plans are offered by employers, they often have the added benefit of an employer match, which is essentially free money toward your retirement. That’s not the case with a Roth IRA.
Another major difference between a 401(k) and the Roth IRA is the contribution limits. In 2022, the IRS allows you to contribute up to $20,500 to your employer-sponsored 401(k) plan, but only $6,000 to a Roth IRA.[3, 4]
A final important difference between 401(k) plans and Roth IRAs is that, in most cases, 401(k) contributions are made pre-tax. Your employer automatically takes them out of your paycheck, your investments grow tax-deferred, and then you pay taxes on the funds when you withdraw them during retirement. That’s not always the case, however.
It’s become increasingly common for employers to offer a Roth 401(k) option, which operates much like a Roth IRA, but through an employer-sponsored plan with a significantly higher contribution limit.
“Some 401(k)s allow for Roth contributions, so then they are similar except for the larger amounts you can contribute to the 401(k),” says Lee. The catch is that the Roth 401(k) contributions are not pre-tax like a regular 401(k) contribution. So if you choose this plan, you will be taxed on that money.
Roth IRA vs. traditional IRA
Roth IRAs and traditional IRAs have many of the same characteristics, with a few key differences.
“The main difference between Roth and traditional IRA is the time of taxation,” says Jake Oyler, a financial advisor for Oyler Investments. “Traditional IRA contributions are taken before income tax, whereas Roth IRA contributions are taken after income tax.”
Because of the different taxation between a traditional and a Roth IRA, there are also slightly different distribution rules. While a Roth IRA allows you to withdraw your contributions at any time without paying taxes or a penalty, that’s not the case with a traditional IRA, since you haven’t yet paid taxes on those funds. If you take early withdrawals—whether it's your contributions or earnings—you’ll pay income taxes and penalties on those funds.
Is a Roth IRA right for you?
In general, a Roth IRA is beneficial for those who expect to be in a higher tax bracket during retirement. It allows them to pay taxes on those contributions now while their taxes are lower. And since many people expect tax rates to increase in the future, a Roth IRA can be a useful way to hedge against that risk.
However, for high-income earners in a high tax bracket today, a Roth IRA might not make the most sense. If you expect to be in a lower tax bracket during retirement, then a traditional IRA or 401(k) plan may have more favorable tax benefits for you.
The good news, according to Oyler, is that you don’t necessarily have to choose one or the other. “My recommendation to all clients is to create a mix of taxable and non-taxable retirement assets. An individual could benefit from having both a Roth and a traditional IRA,” says Oyler.
A few ways you can diversify your tax advantages include:
Splitting your $6,000 IRA contributions between a traditional and a Roth IRA
Contributing to a Roth IRA while also making pre-tax contributions to a 401(k) plan
Roth IRA investments
Once you decide to contribute to a Roth IRA, your next decision is how to invest your contributions. A Roth IRA can hold just about any investment a taxable brokerage account can, but there’s no one-size-fits-all solution.
“Like any investing, there isn’t one specific method that is the best to use when investing Roth IRA assets,” says Oyler. “Everyone has different circumstances, goals, risk preferences, time horizon, etc.”
Some investors choose to diversify their retirement accounts using a variety of mutual funds and exchange-traded funds (ETFs). The target-date fund is a popular retirement savings tool since it’s a diversified fund managed on your behalf. Each fund corresponds to a particular retirement year, and the investment risk in the fund is reduced as you near retirement age.
If you are uncomfortable choosing your own investments for your Roth IRA, a financial advisor or robo-advisor—a digital tool that provides automated financial planning with little or no human supervision—can help pick them on your behalf.