Roth IRA Definition: What It Is & How It Works?

What is a Roth IRA?

Roth IRAs are retirement accounts for individuals that are setup independently of any retirement account tied to employment such as a 401k.

IRA stands for “Individual Retirement Agreement” although you will most commonly see it referenced as “Individual Retirement Account”.

The difference between a Roth IRA and a Traditional IRA is how the account is funded. With a Roth IRA you only fund the account with post-tax income; meaning you have already paid income tax on it. You never pay income tax on the funds invested in the Roth IRA again. A Traditional IRA is tax-deductible today, but you pay income tax in the future.

Individuals open an IRA with a brokerage firm such as (Affiliate 1) and (Affiliate 2).

The flexibility of opening the account yourself provides a lot of great benefits:

  • You get to pick which brokerage firm you want to use based on the criteria that are important to you. The most common criteria to look for are the investment options available and the fees associated with the account. If a broker doesn't carry the investments you want, you move on to another broker. If the fees are too high, you move on to another broker. You aren't tied to a brokerage that your employer chooses.
  • You can like the broker today, but what happens if things change in the future? Not a problem. You can switch to a new broker and take your Roth IRA with you. Simply open a new Roth IRA with a new broker that does carry those investments and roll the funds over from your current account.
  • You get transparent fees. One of the hidden problems of 401ks are the hidden administrative fees and investment costs that aren't easy to find. With a Roth IRA you pick the broker, you see the fees, and you pick the investments you want.

Not everyone is eligible to open a Roth IRA. There are rules and limits in place by the Internal Revenue Service.

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Let's take a look at how this account works:

Roth IRA Rules

Roth IRA Eligibility

Your ability to invest in a Roth IRA during a given tax year is based on two factors:

  • Your tax filing status
  • Your income

There are different income limits based on whether you file your taxes as single, married filing joint, married filing separately, or head of household.

Roth IRA Income Limits

The first row of each tax filing status in the table below shows the maximum modified adjusted gross income (MAGI) you are allowed to have to be able to fund a Roth IRA. If your income exceeds the limit your contribution limit begins to shrink (called a “phase out”) toward zero. If your income exceeds the top end of the phase out range you will be ineligible to fund a Roth IRA for that tax year.

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Note: There are two additional tax filing statuses not shown above: head of household and married filing separately. These two groups may use the single filer limits shown above only if they did not live their spouse at any time in the tax year. If you did live with your spouse at any time in the tax year and you choose head of household or married filing separately on your taxes you will be ineligible to contribute to a Roth IRA for that tax year.

2014 Roth IRA Contribution Limits

For the 2014 tax year you may contribute a maximum of $5,500 to your Roth IRA assuming you meet the income limit requirements above. This contribution limit is tied to inflation and will increase in future years.

However, the IRS does allow individuals nearing retirement age to contribute an additional $1,000 per year as a “catch-up” contribution. If you are age 50 (or older) or will turn age 50 during the tax year you may contribute an additional $1,000 to your Roth IRA for a total maximum contribution of $6,500. This “catch-up” contribution is held to the same income limits shown above.

Roth IRA Fees

Since Roth IRAs are opened by individuals instead of companies you can see the fees associated with having the account with the broker you select. This transparency is good for competition and for consumer choice.

Most brokers won't charge you an account maintenance fee or account setup fee. The only acceptable fee is an account closure/transfer out to another broker fee.

Roth IRA calculator

Benefits of Roth IRA

Roth IRAs are my favorite retirement account thanks to the unique benefits you receive. Most other retirement accounts don't have one of these benefits, not to mention all of them combined:

1. You can contribute to this tax year's Roth IRA up until the tax filing deadline in April of the following year.

For example, your 2014 tax return is due April 15, 2015. You can begin contributing to a Roth IRA today and continue contributing up to the maximum contribution through April 15, 2015. This gives you time to catch up if you are late in getting started with a Roth IRA.

2. You can withdraw your Roth IRA contributions at any time without paying income tax or early withdrawal penalties.

Almost every other retirement account option – especially the tax-deductible options like 401ks and Traditional IRAs – penalize you for withdrawing your contributions before age 59 and ½. If you do make a withdrawal those accounts hit you with an early withdrawal penalty of 10% plus your regular income tax. This can result in a loss of up to 49.6% of your withdrawal depending on your tax bracket.

To be clear, a Roth IRA lets you withdraw the contributions not the growth on those contributions without tax or penalty. If you invested $5,500 in your Roth IRA and it grew to $10,000 over the years you could withdraw the original $5,500 but not the $4,500 in growth. If you do withdraw the growth as well you will be hit with penalties unless you qualify for a hardship exception with the IRS.

3. You pay income tax now and never again.

This really depends on how you feel tax rates will go into the future. Predicting them is a guesser's game, but if you think your tax rate will be higher in retirement than it is today you end up winning by paying tax today with a Roth IRA.

Your Roth is funded with post-tax income. Think of it as what's left on your paycheck after you pay taxes. You take some of that money and invest it in the Roth. When you reach retirement the entire amount within your Roth IRA – contributions and growth – can be withdrawn without income tax.

You trade paying tax today for getting tax-free growth in your Roth until retirement.

Roth IRA Taxes and Fees

As mentioned above you fund your Roth IRA with post-tax income. That income tax is the last you will pay on the money you contribute to the Roth. Over the years the portfolio within your Roth IRA will grow and when you withdraw it you do so without paying income tax on the withdrawal.

The only time you get hit with income tax and penalties is by having an early withdrawal before retirement age and the withdrawal being a larger sum than what you've contributed to the Roth throughout the years.

For example, if you contributed $50,000 into a Roth IRA over 10 years and it grew to $125,000 you could withdraw – at any point – that $50,000 without paying taxes or penalties. Every dollar above that amount would result in taxes and penalties. Let's assume you're in the 25% tax bracket, under age 59 and ½, and don't qualify for any early withdrawal exceptions.

A $60,000 withdrawal from the above scenario would look like this:

  • $60,000 total withdrawal
    • $50,000 from contributions: penalty and tax free
    • $10,000 from growth: income tax and 10% penalty
      • 25% income tax on $10,000: $2,500
      • 10% penalty on $10,000: $1,000
      • Total taxes and penalties: $3,500
  • Net Withdrawal: $60,000 – $3,500 in taxes and penalties = $56,500.

Paying $3,500 to withdraw an additional $10,000 is quite a steep price to pay.

Exemptions to Early Withdrawal Penalties

You can be exempt from paying the 10% early withdrawal penalty if you meet one of the following criteria.

The penalty does not apply if the withdrawal is:

  • Paid out to your estate, heirs, or beneficiaries upon your death
  • Made due to you becoming disabled
  • Made as part of substantially equal payments for your life expectancy
  • For a qualified first-time home purchase
  • Due to owing back taxes or to pay other IRS levies
  • Not larger than your higher education expenses
  • To cover medical expenses larger than 10% of your adjusted gross income for the year
  • To pay medical insurance premiums during a period of unemployment
  • A qualified reservist distribution

How to Open a Roth IRA

Opening a Roth IRA is a relatively simple process.

First, you research brokerage firms and make a decision on which one to open the Roth IRA with. You can have multiple Roth IRAs but your contribution limit each year is for the total of all of your accounts. (In other words you can't contribute $2,500 to three different Roth IRAs as this would exceed the $5,500 contribution limit for the year.)

Then you go online or in-person to fill out account paperwork. For online accounts you will usually be mailed a thick packet of paperwork to sign and send back to the brokerage. This paperwork gets all of your information so the brokerage can report your contributions to the IRS and send you paperwork as necessary.

Once your account is open you fund the account. There are multiple methods to fund an account: link a bank account and electronically transfer funds, mail a check, or transfer/rollover funds from an existing Roth IRA.

Final Note

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2 thoughts on “Roth IRA Definition: What It Is & How It Works?”

  1. My wife and I are starting to work on our retirement plan and the different options can be confusing. Thanks for explaining the difference between Roth IRA and Traditional IRA. I recently opened a Roth IRA, but once I finish graduate school and start working, I may be above the income limit. Is it bad if I have a Roth IRA as well as a traditional IRA? Thanks for the info!

  2. There really are no income limits on a Roth IRA. If an investor earns more income than acceptable, it only takes a few steps to open a Roth IRA. High income earners can open a traditional IRA, then immediately convert it to a Roth IRA. There are no taxes or fees involved. I do this every year online through my broker accounts.

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