Understanding Roth IRAs: The Complete Guide

Understanding Roth IRAs: The Complete Guide

Roth IRAs are a type of retirement account that offer valuable tax benefits - namely tax-free withdrawals and tax-free growth. They were introduced in 1997 and named for Delaware Senator William Roth.

The basic difference between a Traditional IRA and Roth IRA is the way they are taxed. 

  1. Roth IRA contributions are not tax deductible but the withdrawals are 100% tax-free. With a Roth IRA, you pay taxes now, but pay zero taxes on future gains and withdrawals.
  2. Traditional IRA contributions are tax deductible but the withdrawals are counted as income. With a Traditional IRA you save on taxes now but pay taxes later.

If you have heard about Roth IRA but do not know what it's all about, this article can help you out. Here is a complete guide in Roth IRA that helps beginners get insight regarding this account.

Characteristics of Roth IRA

A Roth IRA is a special kind of retirement account where you pay taxes on the money that you deposit in the account. However, any withdrawals from the account in the future are completely tax-free. 

Roth IRAs are great for people who feel their taxes during retirement will be higher than they are during their working years. Even if that assumption does not hold, having a Roth account provides a lot of flexibility during retirement because it allows you to reduce your taxable income.

Even though traditional IRA and Roth IRA are somewhat similar, the latter has a few important characteristics. The key characteristics of Roth IRAs are:

  • The contributions you make cannot be deducted from your taxes.
  • The amount that you contribute for the Roth IRA has to be work income (W-2 wages / salary, or self employment income).
  • The contribution amount for Roth IRAs changes periodically. In 2021, the limit is $6,000 (per person), except if you are 50 years old or more. In this case, the contribution limit is $7,000.
  • If your MAGI (Modified Adjusted Gross Income) in 2021 exceeds $140,000 (singles) or $208,000 (married couples), you cannot contribute to a Roth IRA.
  • It is not mandatory to withdraw money from your Roth IRAs. There are no required minimum distributions for this type of account.
  • To get the distributions and earnings tax-free, the account holder should be at least 59 ½ years old and have the account for a minimum of five years.
  • Roth IRAs can help you control how much taxable income you have later in life, which may allow you to qualify for lower tax rates, better ACA subsidies, etc.

How Can You Open a Roth IRA?

You can open a Roth IRA account at brokerage companies, credit unions, or banks. At brokerage companies you can invest in mutual funds, ETFs or even individual stocks and bonds. 

At credit unions and banks you can typically only hold money market savings or certificates of deposit (CDs) so there is a lot less flexibility with this route.

One important rule about Roth accounts is you have to make contributions before December 31st for the contribution to count for that tax year. There are no extensions given on tax filing for Roth IRAs. In other words if you wait to open the account until the following year you lose that eligibility space in the current year.

If you are really into the idea of Roth contributions, note that there is another type of Roth account called a Roth 401(k). A Roth 401(k) might be an option through your employer sponsored retirement package. Self employed people can also look into opening a Solo 401(k) Roth offered by some brokerages. Contribution limits are much higher for Roth 401(k) accounts. In 2021 the limit is $19,500 per person. However that limit applies to contributions to any type of 401(k) account.

Eligibility Criteria for Roth IRAs

There are two qualifications in order to utilize Roth IRAs. Anyone who matches these qualifications can open and contribute to Roth IRAs. These two qualifications are:

1) Must Have Income from Work

To contribute to a Roth IRA, you must earn income from working (W-2 wages, self employment). As of 2021 you can contribute a maximum $6,000 worth of earned income per year. People who are 50 years old or more can contribute $7,000.

2) Must be Under the Income Limit

You will need to follow the income limit if you want to contribute to Roth IRAs. The limit is $140,000 for singles and $208,000 for married couples. You cannot contribute to Roth IRAs if your income is more than the limit. The contribution amount also has income phase ranges. For more see how MAGI is calculated for the purposes of Roth IRA contributions.

Filing Status


Maximum Annual Contribution

Single, head of household, or married filing separately (if you didn't live with spouse during the year)

Less than $125,000

$6,000 ($7,000 if 50 or older)


$125,000 up to $140,000

Contribution is reduced


$140,000 or more

No contribution allowed

Married filing jointly or qualifying widow(er)

Less than $198,000

$6,000 ($7,000 if 50 or older)


$198,000 up to $208,000

Contribution is reduced


$208,000 or more

No contribution allowed

Married filing separately (if you lived with spouse at any time during the year)

Less than $10,000

Contribution is reduced


$10,000 or more

No contribution allowed


How Do Roth IRAs Distributions and Withdrawals Work?

There are no taxes or penalties on withdrawing your original contributions. You can get that money back at any time, irrespective of the period your account has been open for. Since you have already paid tax on this amount there are no tax consequences, other than losing the contribution space available (you can’t put it back in because of the annual contribution limits). 

Because of this feature some people count their Roth IRA contributions as part of their emergency fund.

Qualified withdrawals of the earnings are also tax-free. However, you might owe a penalty or tax to IRS if you withdraw the earnings early or too soon (5 years since opening a Roth IRA) or you are not 59 ½ years old.

Benefits of Roth IRAs

Some benefits of Roth IRAs are as follows –

You Save on Taxes

Your tax rate might go up in the future. If this is the case, you can save on taxes by paying it now. When you withdraw the earnings in the future, you do not have to pay any additional taxes. As we mentioned above, even if taxes stay the same or go down, having funds in a Roth account is still advantageous because it provides flexibility year to year in managing your overall taxable income in retirement.

Flexible Contributions

The limit for Roth IRA contributions is $6,000 per year, in that calendar year. However, the way you pay this amount is up to you. You can choose to make the contribution as a lump sum, or divide it into monthly or quarterly contributions. Automating your Roth IRA contributions is a good way to save for retirement.

Easy Withdrawals

You will have no problem withdrawing the original contributions you made. However, you will have to pay a 10% penalty if you withdraw the earnings (that is any amount your account grew by) before 5 years of having the account or before you reach the age of 59 ½. 

There are exceptions like a first time home purchase, education expenses, qualified expenses for a birth or adoption, you become disabled, or you use the money to pay for medical expenses if unemployed.

Drawbacks of Roth IRAs

Despite the many advantages, there are a few disadvantages of Roth IRAs:

Cannot Take Loan

You can take loans from 401(k)s; however, you cannot do this from your Roth IRAs. That being said, you can withdraw the original contributions you made if needed.

Taxes Paid Up Front

Let’s say your tax rate is 33%. If you want to contribute $6,000 to a Roth IRA you would have to earn $9,000 in income, pay $3,000 in taxes, to have the $6,000 available to contribute.

With a Traditional IRA if you want to contribute $6,000 you would only need to earn $6,000. The catch is the IRS taxes you when you pull it out in retirement.

Summing Up

Roth IRAs are a great idea for people who want to stay tax-free in their retirement. It is best to start contributing to Roth IRAs during your early working years. They provide flexibility for accessing funds tax free in retirement. They can also count towards an emergency fund since the money is always accessible to you. Since Roth IRA contributions are limited per year it is smart to max out the contributions in years you are able to.

The post Understanding Roth IRAs: The Complete Guide is part of a series on personal finances and financial literacy published at Wealth Meta. This entry was posted in Personal Finance
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