What Is a Roth IRA?

The rules of my trade require explainer headlines like, "What Is a Roth IRA?" In fact, I want to tell you why. Why should you or anyone want a Roth IRA?

Because, in the world of finance, where fun is in very short supply (let me tell you), Roth IRAs offer a delightful surprise.

Tax-free income in retirement!

(In case you already knew that, and you're just here for rules — please skip ahead.)

The rest of us can take a moment to bask in the glow of a retirement account that gives you something to look forward to. Ahhhh.

That said, there are a few pesky rules and restrictions you need to know about opening a Roth IRA. So let's get to it.

IRAs come in two flavors: traditional IRAs and Roth IRAs.

• With a traditional IRA, you deposit money that’s pre-tax, because (generally speaking) it can be deducted from your taxable income for that year. But you will owe tax on any withdrawals down the road. That’s why traditional IRAs are considered tax-deferred accounts.

            No taxes on the money going in. Taxes on the money coming out.

• A Roth IRA is kinda the opposite. You deposit money after it’s taxed, so your contributions are not tax deductible in the year you make them. But, when you take qualified withdrawals in retirement, they are tax free!

            Money taxed going in. Tax-free money coming out.

While a Roth is certainly different from a traditional IRA, there are similarities:

1. The annual limit you can save in an IRA is $7,000 for tax year 2024; $8,000 if you’re 50 or older. And that’s combined. If you have a Roth and a traditional IRA, which is possible, you can’t save more than $7,000 total, across both accounts ($8,000 if you’re at least 50).
   
2. The money in a traditional or a Roth IRA grows tax free in the account. So, the money you deposit, and ideally invest, will see some gains over the years, we hope — but those gains aren’t taxed in the account over time. That means you can keep earning compound interest or capital gains on every penny until you withdraw it.
   
3. Last point: You must contribute earned income to an IRA. If you earned only $5,000, that’s the maximum you can deposit in an IRA for that year. If you’re over 50 and someone gave you an additional $3,000 so you could contribute up to the $8,000 annual limit for 2024, you’d still have to stick with the income you earned: $5,000.

Spousal IRAs are an exception. Here a working spouse can contribute money to an IRA for a spouse who doesn't have earned income. I would look into that if you have a spouse in that situation.

If you've read my other philosophical treatises on money, you know I'm a big believer in taking a pause to absorb all the annoying information that the financial industry expects us to know. Get a cup of coffee, breathe.

For whatever reason, Wall Street has to give everything a special name that it doesn't have in real life. Like: "contributions." Most of us contribute to a cause, a conversation, the Girl Scouts. In finance, specifically in retirement planning, contributions refer to the amount you save.

Why not just call it savings then? I don't know.

And withdrawals are often called distributions. Why? Baffling!

The major wrinkle with a Roth is the income cap: In order to be eligible for a Roth, your income has to fall below certain thresholds, depending on your tax filing status. Following is a helpful chart, but if you need it in English, in a nutshell:

• If you're married, filing jointly, and you earn more than $240,000 in tax year 2024, you can't open a Roth.

• And if you're single or married and filing separately (and didn't live with your spouse during the year), you cannot contribute to a Roth if you earn more than $161,000.

Note that these income eligibility rules apply only to Roth IRAs, not traditional IRAs.

Another point of distinction from traditional IRAs: Roth IRAs offer a nice perk in that you can withdraw the money you've deposited — that is, your principal — at any time tax- and penalty-free. That's because you pay taxes on contributions before putting them in a Roth, so (basically) the IRS doesn't care if you take your money out at any point.

But (there's always a but):

A five-year rule applies to withdrawals of investment earnings (such as capital gains and dividends) in the account. You have to be at least 59½ and have had the Roth account for at least five years in order to take tax-free and penalty-free withdrawals of investment earnings.

Let's say you're 60 years old and you've maxed out your Roth IRA contributions for five years in a row, contributing a total of $40,000. Let's also say your investment earnings added another $4,000, so the total in the account is now $44,000.

Since you're over 59½ and it's been five years since you first funded it, you could take out all your money (principal and earnings), no tax, no penalty.

But if you want to take earnings out of a Roth before age 59½ and you've had it less than five years, you'd owe income tax on the earnings portion of your withdrawal, and possibly a 10% penalty.

The five-year rule applies regardless of your age. If you boldly start a Roth at age 60, even though you're over 59½ you can't take withdrawals of your earnings for five years, or you'll owe a 10% early-withdrawal penalty.

There are some instances where you might not pay the penalty (for example, withdrawals for qualified educational expenses, a first-time home purchase, certain emergencies, and so on). If one of those conditions might apply to you, you may want to read the details about early Roth withdrawals, or consult a professional.

Despite the hurdles and restrictions, Roth IRAs also offer a number of surprising perks, especially when compared with the relatively predictable traditional IRA.

1. Unlike traditional IRAs, from which you are required to start withdrawing money at age 73, Roth IRAs don’t have such so-called required minimum distributions (RMDs). This can be helpful when you’re trying to plan your income in retirement, and you want a certain amount to be tax free, to balance out income from other sources that are taxed.
   
2. It’s possible to convert a traditional IRA to a Roth IRA, but you’d have to pay taxes on the amount you convert. This strategy is one way higher earners can get around the income cap. But it’s an expensive proposition that might only make sense if your current tax bracket is lower than what it might be in retirement.
   
3. It is possible to contribute to a Roth IRA and to a tax-deferred workplace account like a 401(k), 403(b), or SEP-IRA — assuming you don’t exceed the income cap for a Roth IRA, and you mind the contribution limits for each type of account.

In some cases, a 401(k) or 403(b) might include a "designated Roth" option, which could allow you to contribute to the tax-deferred part of the account as well as an after-tax Roth channel within the same account. (I know, weird. But it would accomplish the same end: giving you taxable income as well as tax-free income in retirement.)

You can open a Roth IRA for your kids or grandkids, as long as they have some earned income (babysitting and dog walking count!). You could also open a traditional IRA for a child, but most kids won't benefit from the tax deduction, since minors typically earn less than $14,600, which is the threshold at which they'd have to file a tax return. Might be better to open a Roth, which would give your child or grandchild tax-free retirement income!*

However, if your young progeny have unearned income (say, taxable interest or investment income), that's another story and you may need to consult a professional.

In case you're one of those lucky families with leftover 529 college savings funds, that money can be rolled over into a Roth IRA for your child as well — although there are a few restrictions here.

In short, Roth IRAs are slightly more irritating to deal with than traditional IRAs, owing to the number of rules and restrictions. But generally, the benefits outweigh the headaches. And as we all know, when it comes to retirement, there's usually a wrinkle somewhere. At least this one gives you the potential for tax-free retirement income.

* You might think, based on the number of times I've said "tax-free income in retirement" that I'm either an SEO addict — or someone is paying me a commission. But no. I'm just enthusiastic.

M.P. Dunleavey writes about life and money, as she has for many years, in countless publications (and a book). She lives in New York City with her family and two cats. Read More