How a Roth IRA Works After Retirement

The unique tax, distribution, and inheritance advantages of Roths

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The Roth IRA has skyrocketed in popularity with Americans looking to stash money away for retirement. In mid-2020, Roth IRAs were held by 26.3 million U.S. households, or 20.5%, according to data from the Investment Company Institute.

The Tax Cut and Jobs Act (TCJA), passed in late 2017, also provided a boost for Roths: The income tax rates that the act lowered are set to revert to higher levels in 2026. Since Roth IRAs require you to pay taxes on contributions upfront but none on distributions, they work well for people expecting to be in a higher tax bracket once they retire. So the new law fits right into the Roth's fundamental advantage.

Roth IRAs offer some other unique advantages to savers in terms of taxes, distributions, and the ability to pass wealth on to the next generation.

Key Takeaways

  • Roth IRA accounts are popular investment choices for many investors.
  • You can keep contributing to a Roth IRA after retirement, as long as you have some earned income.
  • Roth IRA contributions aren't tax-deductible on an upfront basis.
  • You can start taking tax-free withdrawals of both contributions and earnings from your Roth IRA once you turn 59½, as long as you've had the account for at least five years.
  • You are never required to take distributions from a Roth IRA and can leave the entire account to your heirs.

Roth IRA: An Overview

Here are a few Roth IRA basics.

Although the Roth IRA shares many similarities with the traditional IRA, there are a few key differences between the two retirement accounts. Contributions to a Roth IRA are not tax-deductible upfront. You pay your contributions out of your current after-tax income. On the other hand, you can withdraw your contribution at any time without penalty.

Once you start taking qualified distributions from a Roth IRA, you are not taxed on the earnings your contributions made over the years. A Roth IRA accrues earnings on a tax-deferred basis, and those earnings will be tax-free.

There is no age limit for making Roth IRA contributions, as long as you have earned income. Finally, Roth IRAs do not have required minimum distributions (RMDs) during your lifetime.

Roth IRA accounts are especially popular with young Americans. More than three in 10 Roth IRA investors are under 40, according to the Investment Company Institute. Nearly a quarter of Roth IRA contributions are made by investors between the ages of 25 and 34, compared to only 7.5% of traditional IRA deposits. And according to Fidelity, Millennials opened 41% of new Roth IRA accounts at Fidelity in 2018.

Traditional IRAs aren't the same as Roth IRAs. They allow for contributions using pre- or after-tax dollars. And your money grows on a tax-deferred basis while withdrawals are taxed as income after you reach the age of 59½.

Making Roth IRA Contributions

As we mentioned earlier, no matter how old you are, you can continue to contribute to your Roth IRA as long as you’re earning income—whether you receive a salary as a staff employee or 1099 income for contract work.

This provision makes Roth IRAs ideal for semi-retirees who keep working a few days a week at the old firm, or retirees who keep their hand in doing occasional consulting or freelance jobs.

Contribution Limits

The maximum Roth contribution for 2021 and 2022 is $6,000, plus $1,000 if you’re 50 or older by the end of the year. This is the so-called catch-up contribution.

Contributions must be made by the tax-filing deadline of the following year, including any extensions. For example, you can make a contribution to your 2020 IRA through April 15, 2021, or later if you file for an extension.

Income Limits

Roth IRAs have income limits that affect whether and how much you can contribute. For example, for the 2021 tax year, single filers must have a modified adjusted gross income (MAGI) under $125,000 ($129,000 for 2022) to be eligible to make a full contribution. They can make a partial contribution if they make between $125,000 and $140,000 for 2021 ($129,000 to $144,000 for 2022), they can make a partial contribution.

You can't pay money into a Roth IRA if you don't have earned income. But your spouse can establish and fund a Roth IRA on your behalf if they still have earned income. Because IRAs cannot be held as joint accounts, the spousal Roth IRA must be in your name even if your spouse is making the contributions.

Taking Roth IRA Distributions

You can withdraw contributions from your Roth IRA at any time and for any reason without taxes or penalties. However, you can't withdraw the earnings in your Roth IRA until you’re at least 59½ and the account has been open for five years or longer.

If you tap into earnings before this time, you will likely have to pay taxes and penalties on the withdrawals. Withdrawals are typically considered as coming from contributions first. So you won't be taking out earnings until you've withdrawn an amount equal to your total contributions.

There are, however, some exceptions to the taxes and penalties. In certain cases, you're allowed to take tax- and penalty-free withdrawals (qualified distributions) from your Roth IRA earnings before you turn 59½.

For example, if you use the money to buy, build, or rebuild a first home for yourself or a family member, it would be considered a qualified distribution. This is limited to $10,000 per lifetime. You may also take distributions for qualified higher-education expenses or if you become disabled.

On the other hand, if you take a non-qualified distribution that does not meet these requirements, you’ll have to cough up income taxes and a 10% early distribution penalty. The source of a non-qualified distribution determines the applicable tax treatment.

Leaving a Roth IRA Inheritance

Because there are no RMDs with a Roth IRA during your lifetime, if you don't need the money for living expenses, you can leave it all to your heirs.

Because you’ve prepaid the taxes on the Roth IRA, your beneficiaries won’t be hit with a tax bill when they receive income from the account. This allows you to leave a stream of tax-free income to your children, grandchildren, or other heirs.

While non-spouse heirs must take RMDs on inherited Roth IRAs, they won’t be taxed on withdrawals as long as they comply with the RMD rules. Again, this differs from traditional IRAs, where RMDs are taxable for beneficiaries, just as they are for the original owners.

The Bottom Line

There’s no question that a Roth IRA offers some valuable benefits after retirement. Not only can you take tax-free withdrawals from a Roth, but you also have maximum flexibility for when and how much you withdraw.

This means you can leave a nice tax-free bundle behind for your heirs, or stagger distributions depending on how much income you are getting from other sources such as Social Security, work, or other investments.

Roth IRAs can be opened at most brokerages, but some provide better access and options than others. If you're shopping around, check out Investopedia's list of the best brokers for IRAs and for Roth IRAs.

Article Sources

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