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RETIREMENT

What is a Roth IRA and how does it work?

What we'll cover

  • Overview of Roth IRAs

  • Quick tips on Roth rules

  • Why you might want to use one

Here’s the great thing about investing for retirement: There are so many ways to do it. 

Roth IRAs are particularly valuable as a retirement savings tool if you are contributing early. 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 if they fit into your plan. But first, gain a solid understanding of Roth IRAs. 

Roth IRA, explained

What is a Roth IRA account? A Roth IRA is an individual retirement account (IRA), a savings tool that provides tax breaks  on retirement savings. Unlike a 401(k), which may be what 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 earmark money for retirement savings, the money you put in them isn’t meant to be taken out until you reach a certain age. Roth IRAs come in 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 is how and when your money is taxed. Money that goes into a Roth IRA has already been taxed, so you won’t have to pay additional taxes when you withdraw during retirement.  

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

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

Because IRAs earmark money for retirement savings, the money you put in them isn’t meant to be taken out until you reach a certain age

Roth IRA contribution limits

If you’re starting your career, a Roth IRA is an ideal way to put money away for later. You may 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 2023

All IRAs, not just Roth IRAs, have contribution limits . An individual can contribute a maximum amount of $6,500 annually (in 2023) to a Roth IRA if you’re 49 and younger. If you’re 50 or older, you can contribute $7,500 per year (in 2023), which is known as a “catch-up” contribution.  

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.

Remember 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 and a 10% IRS penalty. The IRS allows certain early withdrawals (including wages) without penalty if you fall on hard times. 

What is the five-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.  If the Roth IRA five year-rule holding period is met prior to turning age of 59 ½, while tax on the earnings is avoided, the 10% early withdrawal penalty typically still applies. See withdrawals without penalty (in some situations) below for more information. 

Can I take money out of my Roth IRA and put it back later?

You can take money out of your Roth IRA without paying taxes and penalties if you apply the 60-day rollover rule. You must repay the full amount within 60 days, which 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 can 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 for 2023

Roth IRA Income Limits
Filing Status Modified Adjusted Gross Income (AGI) Amount You Can Contribute
Married filing jointly or qualifying widow(er) Less than $218,000  $6,500 or $7,500 if  age 50 or older
Married filing jointly or qualifying widow(er)  Greater than (or equal to) $218,000 but  less than $228,000 A reduced amount 
Married filing jointly or qualifying widow(er)  Greater than (or equal to) $228,000 $0
Married filing separately and you lived with your spouse at any time during the year Less than $10,000 A reduced amount 
Married filing separately and you lived with your spouse at any time during the year Greater than (or equal to) $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 Less than  $138,000  $6,500 or $7,500 if  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 Greater than (or equal to) $138,000 but less than $153,000 A reduced amount 
Single, head of household or married filing separately and you did not live with your spouse at any time during the year Greater than (or equal to) $158,000 $0

What are the benefits of a Roth IRA?

Are you still on the fence about putting 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 your tax rate will be higher than now, a Roth IRA might be a great match. When you start making withdrawals in retirement, you get to keep every penny. 

  • Withdrawals 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. While you may avoid the 10% early withdrawal penalty in certain situations, the withdrawals are still taxed as ordinary income unless you meet the five-year Roth IRA holding period. There are other exceptions to for possibly avoiding the 10% early withdrawal penalty, such as if you use the withdrawal to pay for a first- ime 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 73 (starting in 2023), there are no required RMDs. This means your investments can stay in your account for as long as you want and continue growing tax-free. 

  • Your beneficiaries' benefit: Your beneficiaries generally 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 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 typically pay taxes at retirement. It’s important to understand when you want to take your tax hit. If you believe your retirement tax rate will lower, a traditional IRA might make more 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 retirement accounts. An individual can only contribute $6,500 in 2023 ($7,500 if age 50 or older). It’s generally 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 $22,500 in 2023 ($30,000 for those age 50 or older). A 401(k) plan is a tax-advantaged retirement account employers provide.  

  • Income limits: You cannot contribute to a Roth IRA if your income exceeds a certain limit. Check the current income limits above (or visit the IRS website) to ensure 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:

  • Pre-tax payroll deductions fund them.

  • 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 $22,500 for an individual versus the $6,500 limit for a traditional or Roth IRA in 2023, so 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. 

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 Ally Bank or Ally Invest . No matter what you decide, setting up an account can be completed in just minutes.

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