Roth IRA Explained: How It Works & Benefits for Retirement

Here’s the great thing about investing for retirement: You have so many different options!

Keep Roth IRAs on your list, because they’re one of the most valuable retirement savings tools available, especially if you start contributing early. Plus, Roth IRAs have some unique characteristics that set them apart from traditional IRAs.

Don’t miss the boat on getting one of these tax-advantaged accounts working in your favor. Here’s what you need to know.

Roth IRA, explained

A Roth IRA is an individual retirement account (IRA); a savings tool that provides tax breaks on retirement savings. Unlike a 401(k), which is offered by the company you work for, you open an IRA outside of your employer’s retirement plan. All you need is taxable income to become eligible for an IRA at a brokerage firm or bank.

Because IRAs are designed for retirement savings, the money you put in them isn’t meant to be taken out until you’ve reached a certain age. Roth IRAs come in the form of investment accounts, certificates of deposit (CDs) or savings accounts.

How does a Roth IRA work?

Different types of IRAs have their own rules and tax benefits. The most important difference between Roth and traditional IRAs has to do with how and when your money is taxed.  Money that goes into a Roth IRA has already been taxed, which means you won’t have to pay additional taxes when you make withdrawals during retirement.

Traditional IRA contributions are tax-deductible in the calendar year you make those contributions, and distributions made during retirement are taxed at your current tax rate.

Roth IRAs happen to be the fastest-growing type of IRA because of their unique tax advantages and other saver-friendly characteristics.

Roth IRA contribution age limits

If you have earned income, you can contribute to your Roth IRA at any age. This contrasts with traditional IRAs, which you can’t make regular contributions to after you turn 70½.

If you’re just getting started in your career, a Roth IRA is an ideal way to put money away for later. You may potentially have decades of tax-free growth and compounding interest to benefit from. By starting early and contributing the maximum allowable amount, you can take full advantage of what experts call the time value of money.

Roth IRA maximum contribution limits for 2022

All IRAs, not just Roth IRAs, have contribution limits. An individual can contribute a maximum amount of $6,000 per year to a Roth IRA if you’re 49 and younger. If you’re 50 or older, you can contribute $7,000 per year, which is known as a “catch up” contribution.

Note that rollover contributions, which occur when you move funds from a 401(k) or another qualified retirement account to a Roth IRA, do not count toward the maximum contribution limit.

Even if your income allows you to be eligible to open a Roth IRA, your income and tax filing status may affect whether you can contribute the maximum amount each year.

Roth IRA withdrawal rules

As previously mentioned, you fund a Roth IRA with post-tax dollars, so you don’t have to worry about paying taxes on your earnings or qualifying withdrawals.

Keep in mind that money taken out before age 59½ is considered an early withdrawal. You can withdraw your original contributions at any time, tax and penalty-free. However, if that withdrawal includes any earnings, you’ll pay taxes on them and a 10% IRS penalty. Certain early withdrawals (including wages) are allowed without penalty by the IRS should you fall on hard times.

What is the 5-year rule for Roth IRA?

Once you reach age 59½, you can withdraw your funds — including earnings — tax-free, if the money has been in the IRA for at least five years.

Can I take money out of my Roth IRA and put it back in 60 days?

You can take money out of your Roth IRA without paying taxes and penalties as long as you apply the 60-day rollover rule. You must repay the full amount within 60 days. This even applies to nonqualified distributions.

Roth IRA income limits

The IRS uses a formula to determine Roth IRA limits based on your income and filing status. Visit the IRS website to see if and how much you are eligible to contribute based on the government-set limits.

If you make too much money to open a Roth IRA, you may be able to convert some of the assets in your traditional IRA to a Roth. Read on to learn more about converting to a Roth IRA.

Roth IRA Income limits

Filing Status	Modified Adjusted Gross Income (AGI)	Amount You Can Contribute
Married filing jointly or qualifying widow(er)	< $204,000	Up to the limit of $6,000 ($7,000 if you're age 50 or older)
Married filing jointly or qualifying widow(er)	> $204,000 but < $214,000	A reduced amount compared to the limit
Married filing jointly or qualifying widow(er)	> $214,000	$0
Married filing separately and you lived with your spouse at any time during the year	< $10,000	A reduced amount compared to the limit
Married filing separately and you lived with your spouse at any time during the year	$10,000	$0
Single, head of household, or married filing separately and you did not live with your spouse at any time during the year	< $129,000	Up to the limit of $6,000 ($7,000 if you're age 50 or older)
Single, head of household or married filing separately and you did not live with your spouse at any time during the year	> $129,000 but < $144,000	A reduced amount compared to the limit
Single, head of household or married filing separately and you did not live with your spouse at any time during the year	> $144,000	$0

What are the benefits of a Roth IRA?

Still on the fence about whether you should put your hard-earned money into a Roth IRA? A Roth IRA has several perks, including:

• Tax-free income: You don’t have to pay taxes when you withdraw your money in retirement. If you believe that your tax rate will be higher than it is now, a Roth IRA might be a great match. When you start making withdrawals in retirement, you get to keep every single penny.
• You can withdraw without penalty in some situations: Normally, you’d pay taxes and penalties if you take money out of your retirement account early. If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, you’ll pay taxes and penalties. If you’re under age 59½ and your Roth IRA has been open five years or more, your earnings will not be subject to taxes if you use the withdrawal to pay for a first-time home purchase (up to a $10,000 lifetime maximum), qualified education expenses, qualified expenses related to a birth or adoption, you become disabled or die, must pay for unreimbursed medical expenses or health insurance if you’re unemployed and if the distribution is made in substantially equal periodic payments. Check into Roth IRA rules and Roth IRA withdrawal rules before you withdraw.
• No required minimum distributions (RMDs): Unlike traditional IRAs, which require you to withdraw from your accounts at age 72, there are no required RMDs. This means that your investments can stay in your account for as long as you want and can continue to grow tax-free.
• Your beneficiaries’ benefit: Your beneficiaries can receive distributions tax-free through a Roth IRA. In the case of a traditional IRA, your beneficiaries would have to pay taxes on withdrawals that are passed down to them.

What is the downside of a Roth IRA?

Before you make a final decision, it’s worth looking at the disadvantages of a Roth IRA:

• Upfront taxes: You must pay taxes upfront for a Roth IRA, whereas a traditional IRA requires you to pay taxes at retirement. It’s important to understand when you want to take your tax hit. If you believe that your tax rate will be lower in retirement, a traditional IRA might make the most sense for your situation.
• Low limits: You can’t contribute as much money to a Roth IRA as you can with a 401(k) or other types of retirement accounts. An individual can only contribute $6,000 in 2022 ($7,000 if age 50 or older). It’s a good idea to consider contributing to both a 401(k) and a Roth IRA because for a 401(k) an individual can contribute a maximum of $20,500 in 2022 ($27,000 for those age 50 or older). A 401(k) plan is a tax-advantaged retirement account provided by employers.
• Income limits: You cannot contribute to a Roth IRA if your income is over a certain limit. Check the income limits listed above to make sure you can contribute the full amount to a Roth IRA.

What is better, a 401(k) or a Roth IRA?

Which makes the most sense for your needs — a 401(k) or Roth IRA? First, a quick overview of 401(k) plans:

• They are funded by pre-tax payroll deductions.
• Employers may choose to match employee contributions.
• Funds in a 401(k)-grow tax-deferred until you withdraw them after retirement.

You can contribute an annual amount to a 401(k) if your contribution amount does not exceed the IRS limits.

A 401(k) plan has a higher contribution limit of $20,500 for an individual versus the $6,000 limit for a traditional or Roth IRA in 2022 It may be more advantageous to contribute to a 401(k), particularly because many employers offer a Roth 401(k) option. A Roth 401(k) is an employer-sponsored retirement savings account funded using after-tax dollars. Income tax pays out immediately on the earnings and withdrawals from the account are tax-free when you take them out in retirement.

How to open a Roth IRA

Once you’ve decided a Roth IRA is right for you and your financial situation, you’ll find they’re simple to open at your local bank, an online bank like Ally Bank or brokerage like Ally Invest, or with help from your financial advisor.

If you decide to open a Roth IRA with us, you have several options. First, choose between an Ally Bank Online Savings Account, IRA High Yield CD or IRA Raise Your Rate CD or an IRA investment account with Ally Invest. No matter which you decide, setting up an account is easy to do and can be completed in just minutes by following our guided signup process.

Learn more: Here’s how to open an IRA in three simple steps.

Should you choose to open an Ally Invest investment account for your Ally Roth IRA, you can decide between Self-Directed Trading or a Robo Portfolio. Either way, you’ll receive the great benefits a Roth IRA provides while getting as much or as little investing assistance as you prefer.

Is now the right time to convert to a Roth IRA?

A Roth IRA can be a useful tool for growing your retirement savings. But it’s a good idea to weigh whether converting to one from a traditional IRA is right for you based on factors like your income and age.

You should also consider any tax implications before converting a traditional IRA to Roth. This is because when you convert a traditional IRA to a Roth IRA, you have to pay taxes on those funds, which may result in a substantial tax bill. If you are thinking about making this conversion, be sure to speak with a tax professional to fully understand if doing so makes sense for your situation.

A better retirement begins today.

Saving for retirement doesn’t need to be overly complicated, especially when using a tool like a Roth IRA. In fact, the toughest step may just be deciding to open one. Then, put your savings on autopilot and enjoy the benefits of potentially earning tax-free returns.

Save your way with Ally: Traditional or Roth IRA?