The Essential Guide to the Roth IRA

What to know about this popular retirement account.

A Roth IRA is one of the many retirement accounts allowed under the U.S. tax code. IRA stands for individual retirement account, and this specific kind of IRA lets you save money after taxes for tax-free growth later. These accounts offer all kinds of advantages and flexibility, making them a great way to begin investing for retirement. If you understand how to use them properly, they can be powerful tools for retirement saving and reducing your future taxes.

A Brief History of the Roth IRA

The Roth IRA traces its origin to 1997, when it was created as part of the Taxpayer Relief Act of 1997 (the same bill that introduced the child tax credit). The account is named after Delaware Senator William Roth, who initially proposed the idea in 1989. They first became available in 1998 when the contribution limit was just $2,000.

Roth IRA Benefits

A Roth IRA offers numerous benefits to investors:

1. (Almost) Anyone Can Contribute

Pretty much anyone can open a Roth IRA. So long as you have earned income, which means income from a W2 job or 1099 work (rental income does not apply), you can contribute to a Roth IRA. This makes it a great option if you don’t have a retirement plan at work. You can contribute as much as $6,000 in a tax year with an additional $1,000 catch-up contribution if you’re over 50. But you can start a Roth IRA with as little as $100 or less depending on the brokerage.

A Roth IRA comes with income limitations on contributions.¹ So if you’re a single tax filer with an adjusted gross income (AGI) of $125,000 or less, you can make a full contribution. Your contributions are reduced until you have an AGI of $140,000, when your allowed contribution is $0. If you’re married filing jointly, you can make a full contribution with an AGI of $198,000 with a phaseout period until $208,000.

You have until the tax filing deadline to contribute. So for 2021, you have until April 18, 2022 to contribute to your Roth IRA. This gives you a 16-month window to max out your contributions for a given tax year.

You can have as many Roth IRA accounts as you want, but you cannot exceed $6,000 in contributions each year.

2. Huge Tax Advantages

Roth IRAs offer huge tax advantages. Even though you don’t get a deduction for your contributions, once you contribute money and invest it, you’ll never be taxed again on your earnings and investment gains. This can make it a powerful tool for long-term investing.

If you start investing early enough, your earnings in the account may be many multiples of your contributions by the time you retire, none of which will be taxed.

And even though you won’t get a deduction for contributions, you may qualify for the Saver's Credit when you file your taxes.

3. Withdrawal Flexibility

The Roth IRA is among the most flexible tax-advantaged investment vehicles. There are two components to the money inside a Roth IRA: contributions and earnings. Since you’ve already paid taxes on contributions, you can withdraw them at any time, tax- and penalty-free. The earnings are generally subject to a 10% penalty and income taxes if you withdraw them before age 59.5. After 59.5, you can withdraw the entirety of your Roth account without taxes or penalties.

There are also specific circumstances that allow you to withdraw your earnings before 59.5 without incurring the 10% penalty, such as for unreimbursed medical expenses, to pay for medical insurance in the event of a job loss, or for childbirth or adoption expenses. You can also use up to $10,000 in earnings to buy your first home or $5,000 for education expenses.

Generally, you’ll still owe income taxes on the money you withdraw, unless five years have passed since you opened a Roth IRA, in which case no taxes will be due in the event you take a distribution for a first home or for a disability. If that sounds complicated, it’s because it is. So if you plan on taking an early distribution, make sure you understand the specific rules around it.

4. Choose Your Own Investments

Unlike with a workplace retirement account, you have pretty broad freedom to choose whatever stock, ETF or mutual fund you want to invest in. So you can open an account at your brokerage of choice and invest in low-cost index funds. Or you can invest some of your money in higher-risk actively managed funds or buy shares in individual stocks to your liking.

More Ways to Access a Roth

What if you’re a stay-at-home parent with no income, or you’re over the income limit to make a direct contribution? Here are other ways you can access a Roth IRA.

The Spousal Roth

Retirement accounts are by nature individual. There’s no such thing as a joint retirement account. And in order to contribute to a retirement account, you usually need to have earned income. But if one spouse works and the other one doesn’t, the non-working spouse can open a Roth IRA and make the maximum contribution, as long as their household income exceeds the contributions. In other words, in order for both spouses to make their $6,000 annual contribution, they must have a household income of at least $12,000.

The Spousal Roth isn’t a special type of account, it simply refers to the ability of a non-working spouse to contribute to a Roth IRA using overall household income to meet the earned income requirement. This only works if a married couple files their taxes jointly.

A Roth Conversion

A Roth conversion involves taking money in a pre-tax account, like a traditional IRA, and converting that money to a Roth account by paying taxes on the conversion. So if you have $10,000 in a traditional IRA and you want to convert it to a Roth account, you will have to pay taxes on that money according to your tax rate.

The Backdoor Roth

The backdoor Roth is a strategy created in 2006 with the Tax Increase Prevention and Reconciliation Act of 2005, and the provision allowing the backdoor Roth IRA went into effect in 2010. The act removed income limits on making Roth conversions, allowing higher income individuals who are cut off from making direct contributions to get money into a Roth IRA.

Because those who are over the income limit to make direct Roth contributions are also over the income limit to receive a tax deduction for a traditional IRA contribution, you must make a non-deductible contribution to a traditional IRA. This simply means you contribute without receiving a tax deduction. You then convert your traditional IRA money to a Roth IRA. Normally when you convert traditional IRA assets to a Roth account, you will owe taxes. But since the non-deductible IRA contributions have already been taxed, and as long as there are no gains in the account since making the contribution, you will owe no taxes.

Keep in mind that if you already have assets in traditional accounts like an IRA, a SEP-IRA or a SIMPLE IRA, the backdoor Roth gets messier due to the IRS’s pro rata rule.

The Mega Backdoor Roth

The mega backdoor Roth is an advanced strategy that requires a 401(k) plan with two features: the ability to make in-service withdrawals and the ability to make after-tax non-Roth contributions.

In short, a 401(k) plan can have four possible subaccounts. The three most common are an employee pre-tax account, an employee after-tax Roth account and an employer pre-tax account where matching contributions go. The mega backdoor Roth requires a fourth account: an after-tax non-Roth account.

Employee limits for 401(k) contributions are limited to $19,500 for 2021,² and the combined employer and employee limits for contributions to the plan are $58,000. So the combined limit you can make to your pre-tax and Roth 401(k) accounts is $19,500. But the existence of that fourth type of account, the after-tax non-Roth account, allows you to go above and beyond that. You could theoretically put $19,500 in a Roth 401(k) account and then $38,500 in the after-tax non-Roth account.

If your 401(k) plan allows you to make in-service withdrawals, you could rollover that money to your Roth IRA account, thus effectively allowing you to make a $58,000 contribution to a Roth IRA.

Very few employers offer a 401(k) with all these features, and keep in mind that employer contributions will count toward the $58,000 limit, possibly reducing what you can contribute as part of the mega backdoor Roth strategy.

A Rollover Roth

If you have a Roth 401(k) or Roth 403(b) at work, you can use these vehicles to put money in after-tax. When you leave your job, you can roll over funds from your Roth 401(k) or Roth 403(b) to your Roth IRA, subjecting your money to all the same Roth IRA rules. Since there are no income limits for Roth workplace accounts, and there are much higher contribution limits to these accounts, this allows you to effectively contribute $19,500 a year into Roth accounts regardless of your income. You can also do this in conjunction with regular Roth IRA contributions, for a total of $25,500.

How to Open a Roth IRA

You can open a Roth IRA almost anywhere that lets you invest, such as Vanguard, Fidelity, Charles Schwab, Betterment and M1 Finance. The setup time generally takes under 30 minutes as you fill out some forms and connect a checking account to fund your Roth IRA.

Everyone interested in investing for retirement should be familiar with the Roth IRA. Most people will be able to make a direct contribution and not have to worry about the more advanced strategies described here. But regardless of your income, having tax-free funds in retirement can be a huge benefit.

1. The income limits for contributing to a Roth IRA rise in 2022. Single filers can make a full contribution at an AGI of $129,000 or less with a phaseout period until $144,000. Joint married filers can contribute at $204,000 with a phaseout period until $214,000.

2. The contribution limits for a 401(k) rise to $20,500 in 2022 and the catch-up contribution remains $6,500 if you’re over 50. The overall limit will be $61,000.