What Is a Roth IRA?

Named for Delaware Senator William Roth and established by the Taxpayer Relief Act of 1997, a Roth IRA is an individual retirement plan (a type of qualified retirement plan) that bears many similarities to the traditional IRA. The biggest distinction between the two is how they’re taxed.

Traditional IRA contributions are generally made with pretax dollars; you usually get a tax deduction on your contribution and pay income tax when you withdraw the money from the account during retirement. Conversely, Roth IRAs are funded with after-tax dollars; the contributions are not tax deductible—although you may be able to take a Saver's Tax Credit of 10% to 50% of the contribution, depending on your income and life situation. But once you start withdrawing funds, qualified distributions (see below) are tax free.

Key Takeaways

  • A Roth IRA is a type of qualified individual retirement account that accrues gains tax-exempt, but uses after-tax money to fund it.
  • This can be contrasted with a traditional IRA which uses pre-tax funds and then defers that income tax until the time of withdrawal.
  • Annual Roth IRA contributions are capped, and eligibility is subject to income restrictions.
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Roth IRA Vs. Traditional IRA

How a Roth IRA Works

Similar to other individual retirement plan accounts, the money invested within the Roth IRA grows tax free. Other defining characteristics of a Roth:

  • Contributions can continue to be made once the taxpayer is past the age of 70½, as long as he or she has earned income.
  • The taxpayer can maintain the Roth IRA indefinitely; there is no required minimum distribution (RMD) during the account holder's lifetime.
  • Eligibility for a Roth account depends on income.

For the 2019 tax year, an individual can make an annual contribution of up to $6,000 to a Roth IRA. (In 2018, that figure was $5,500.)

Individuals who are age 50 and older by the end of the year for which the contribution applies can make additional catch-up contributions (up to $1,000 in 2018 and 2019). For instance, an individual who is under age 50 may contribute up to $6,000 for tax year 2019, ($7,000 for those 50+). 

All regular Roth IRA contributions must be made in cash (which includes checks); regular Roth IRA contributions cannot be made in the form of securities. However, a variety of investment options exist within a Roth IRA, once the funds are contributed, including mutual funds, stocks, bonds, ETFs, CDs and money market funds.

A Roth IRA can be funded from a number of sources:

  • Regular contributions
  • Spousal IRA contributions
  • Transfers
  • Rollover contributions
  • Conversions

Important

Consider opening a Roth if you qualify and are more interested in tax free income when you retire than in a tax deduction now, when you contribute.

Establishing a Roth IRA

A Roth IRA must be established with an institution that has received IRS approval to offer IRAs. These include banks, brokerage companies, federally insured credit unions, and savings and loan associations. Generally, individuals open IRAs with brokers.

A Roth IRA can be established at any time. However, contributions for a tax year must be made by the IRA owner’s tax-filing deadline, which is generally April 15 of the following year. Tax-filing extensions do not apply.

There are two basic documents that must be provided to the IRA owner when an IRA is established:

These provide an explanation of the rules and regulations under which the Roth IRA must operate, and establish an agreement between the IRA owner and the IRA custodians/trustee.

IRAs fall under a different insurance category than conventional deposit accounts. Therefore, coverage for IRA accounts is less. The Federal Deposit Insurance Corporation (FDIC) still offers insurance protection up to $250,000 for traditional or Roth IRA accounts, but account balances are combined rather than viewed individually. For example, if the same banking customer has a certificate of deposit held within a traditional IRA with a value of $200,000 and a Roth IRA held in a savings account with a value of $100,000 at the same institution, the account holder has $50,000 of vulnerable assets without FDIC coverage.

Not all financial institutions are created equal. Some IRA providers have an expansive list of investment options, while others are more restrictive. Almost every institution has a different fee structure for your Roth IRA, which can have a significant impact on your investment returns.

Your risk tolerance and investment preferences are going to play a role in choosing a Roth IRA provider. If you plan on being an active investor and making lots of trades, you want to find a provider that has lower trading costs. Certain providers even charge you an account inactivity fee if you leave your investments alone for too long. Some providers have more diverse stock or exchange-traded fund offerings than others; it all depends on the type of investments you want in your account.

Pay attention to the specific account requirements as well. Some providers have higher minimum account balances than others. If you plan on banking with the same institution, see if your Roth IRA account comes with additional banking products. If you're looking at opening a Roth at a bank or brokerage where you already have an account, see whether existing customers receive any IRA fee discounts.

Qualifying for Roth Compensation

For individuals working for an employer, compensation that is eligible to fund a Roth IRA includes wages, salaries, commissions, bonuses and other amounts paid to the individual for services they perform for an employer. Eligible compensation is generally any amount shown in Box 1 of the individual's Form W-2.

For a self-employed individual or a partner in a partnership, compensation is the individual’s net earnings from their business, less any deduction allowed for contributions made to retirement plans on the individual’s behalf, and further reduced by 50% of the individual’s self-employment taxes.

Other compensation eligible for the purpose of making a regular contribution to a Roth IRA includes taxable amounts received by the individual because of a divorce decree.

The following sources of income are not eligible compensation for making contributions to a Roth IRA:

  • Rental income or other profits from property maintenance
  • Interest income
  • Pension or annuity income
  • Stock dividends and capital gains

The Spousal Roth IRA

An individual may establish and fund a Roth IRA on behalf of their spouse who earns little or no income. Spousal Roth IRA contributions are subject to the same rules and limits as regular Roth IRA contributions. The spousal Roth IRA must be held separately from the Roth IRA of the individual making the contribution, as Roth IRAs cannot be held as joint accounts.

For an individual to be eligible to make a spousal Roth IRA contribution, the following requirements must be met:

  • The couple must be married and file a joint tax return.
  • The individual making the spousal Roth IRA contribution must have eligible compensation.
  • The total contribution for both spouses must not exceed the taxable compensation reported on their joint tax return.
  • Contributions to one Roth IRA cannot exceed the contribution limits for one IRA (however, together the two accounts allow the family to double their annual savings).

Eligibility Requirements

Anyone who has taxable income can contribute to a Roth IRA—as long as they meet certain requirements concerning filing status and modified adjusted gross income (MAGI). Those whose annual income is above a certain amount, which the IRS adjusts periodically, become ineligible to contribute. The chart below shows the figures for 2019.

Do You Qualify for a Roth?
Category Income Range for 2019
Married and filing a joint tax return At least $193,000, but less than $203,000 
Married, filing a separate tax return and lived with spouse at any time during the year More than zero, but less than $10,000
Single, head of household, or married filing separately without living with spouse at any time during the year At least $122,000, but less than $137,000 

These individuals must use a formula to determine the maximum amount they may contribute to a Roth IRA. An individual who earns less than the ranges shown for his or her appropriate category can contribute up to 100% of his or her compensation or the contribution limit, whichever is less. 

Withdrawals: Qualified Distributions

At any time, you may withdraw contributions from your Roth IRA both tax- and penalty-free. If you withdraw only the amount of your Roth contributions, the distribution is not considered taxable income and is not subject to penalty, regardless of your age or how long it has been in the account. Roth withdrawals are made on a FIFO basis (first in, first out)—so any withdrawals made come from contributions first. Therefore, no earnings are considered withdrawn until all contributions have been withdrawn.

For a distribution of account earnings to be qualified, it must occur at least five years after the Roth IRA owner established and funded his/her first Roth IRA, and the distribution must occur under at least one of the following conditions:

  • The Roth IRA holder is at least age 59½ when the distribution occurs.
  • The distributed assets are used toward the purchase—or to build or rebuild—a first home for the Roth IRA holder or a qualified family member (the IRA owner's spouse, a child of the IRA owner and/or of the IRA owner's spouse, a grandchild of the IRA owner and/or of their spouse, a parent or other ancestor of the IRA owner and/or of their spouse). This is limited to $10,000 per lifetime.
  • The distribution occurs after the Roth IRA holder becomes disabled.
  • The assets are distributed to the beneficiary of the Roth IRA holder after the Roth IRA holder's death.

Withdrawals: Non-Qualified Distributions

A withdrawal of earnings that does not meet the above requirements is considered a non-qualified distribution and may be subject to income tax and/or a 10% early-distribution penalty. There may be exceptions, however, if the funds are used:

  • For unreimbursed medical expenses. If the distribution is used to pay unreimbursed medical expenses for amounts that exceed 10% of the individual's adjusted gross income (AGI) for the year of the distribution. (That 10% number starts in 2019; for 2018 it was 7.5% of the AGI.)
  • To pay medical insurance. If the individual has lost his or her job.
  • For qualified higher-education expenses. If the distribution goes toward qualified higher-education expenses of the Roth IRA owner and/or his or her dependents. These qualified education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution and must be used in the year of the withdrawal.

There is yet another loophole for earnings: If you withdraw only the amount of your contributions made within the current tax year—including any earnings on those contributions—they are treated as if they were never made. If you contribute $5,000 in the current year and those funds generate $500 in earnings, you can withdraw the full $5,500 tax-free and penalty-free if the distribution is taken before your tax filing due date.

Roth IRA vs. Traditional IRA

Whether or not a Roth IRA is more beneficial than a traditional IRA depends on the tax bracket of the filer, the expected tax rate at retirement, and personal preference. Individuals who expect to be in a higher tax bracket once they retire may find the Roth IRA more advantageous since the total tax avoided in retirement will be greater than the income tax paid on the contribution amount in the present. Therefore, younger and lower-income workers may benefit the most from the Roth IRA. Indeed, by beginning to save with an IRA early in life, investors make the most of the snowballing effect of compound interest: Your investment and its earnings are reinvested and generate more earnings, which are reinvested and so on.

High wage earners who expect a lower tax rate in retirement can also benefit from a Roth IRA. Many investors simply prefer to receive a tax-free income stream in retirement. And those who don't need their Roth IRA assets in retirement can leave the money to accrue indefinitely—required minimum distributions (RMDs) after age 70½ don't apply to these accounts—and pass the assets to heirs tax-free upon death. (Even better, while the beneficiary must take distributions from an inherited IRA, they can stretch out tax deferral by taking distributions based on how long they are expected to live). Also, a spouse can roll over an inherited IRA into a new account and not have to begin taking distributions until age 70½.

Some open or convert to Roth IRAs because they fear an increase in taxes in the future, and this account allows them to lock in the current tax rates on the balance of their conversions. Executives and other highly compensated employees who are able to contribute to a Roth retirement plan through their employers [for example, a Roth 401(k)] can also roll these plans into Roth IRAs with no tax consequence and then escape having to take mandatory minimum distributions when they turn 70½.