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

Donny Gamble
April 3, 2022
Roth IRA definition
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Are you trying to invest money into your future, but don’t want to mess around with the stock market? What if you want to invest but you don’t have a ton of money to throw down?

That’s where Roth IRAs come into play. There are benefits and setbacks with this type of retirement account, but overall, they are beneficial for just about anyone who uses them.

We’ll cover all the ins and outs that you need to know while also trying to figure out how you can best invest your money in a Roth IRA so you can maximize your return (yes, there are tactics even with retirement accounts).

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What is a Roth IRA?

IRAs are individual retirement accounts. A Roth IRA is similar, except that the money in your Roth IRA is not tax-deferred income.

This individual retirement account will begin earning money on your investments just like with a self-directed IRA, but with deposit/contribution limitations.

How Roth IRA Taxes Work?

You earn money, and then tax is taken out. Then that money is eligible to go into a Roth IRA. Unlike a 401(k) where your pre-tax money can be contributed (only to be taxed later on), you’ll be able to technically contribute less because of this.

With a Roth IRA, though, you are not taxed when you withdraw money from it once it’s reached the age of maturity. There’s a stipulation on withdrawal later on that you’ll have to know about before you both contribute money to your Roth IRA.

Roth IRA Contribution Limits for 2022

You can only contribute $6,000 per year when you sign up for a Roth IRA. If you are over the age of 50, you can contribute up to $7,000 in a calendar year.

There is no way around this, and later on we have more about your income and contribution level that will absolutely impact how you’re able to set up your retirement.

Should You Maximize Your Contribution Early in the Year?

Your retirement plan is to use as little money as possible to grow into as much money as possible. You don’t want to contribute half of your income into retirement each year (not that you can with a Roth IRA anyway), otherwise you would end up reducing your quality of life now for a better quality of life later.

When you invest in your Roth IRA, that money in your retirement plan is invested and begins to accrue interest. This is usually paid out monthly.

If you contribute $500 per month to reach that $6,000 limit by the end of the year, that’s great! You were still able to maximize your retirement contributions.

But if you have the option, you should max out your IRA as early as possible into the new year. If you do, you’ll earn interest on that $6,000 maximum in January.

Then, compounded into more money, that new (higher) balance earns you interest into February, and so on.  $500 invested in January is worth more money by the end of the year than $500 invested during any later month.

The earlier you get started, the better off your retirement account will be, and the more money you’ll have. If nothing else, consider contributing your tax return to your Roth IRA each year.

Roth IRA Income Limits

Roth IRA programs are meant to service those with low income levels, or at least income underneath a certain threshold. Once you begin making over a certain tax bracket amount of money, you can no longer contribute to your Roth IRA.

Don’t worry, though; that account is still earning interest and the money is still yours. You did contribute, after all, during a time when your income level was lower or your tax bracket situation was different, so it was all legal.

Now, you can diversify your retirement by contributing to a 401(k).  The major issue with your Roth IRA tax bracket changes are:

  • When a child reaches an age where they are no longer increasing the ceiling on your maximum tax bracket income level.
  • They can change depending on the IRS laws that go into effect.

Keep up-to-date on news about IRS laws and where they change the tax brackets every year. This information will be visible in your tax filing software, or you can ask your tax specialist if you need to.

Bottom Line

Before you sign up for a Roth IRA, understand your income level and if it’s acceptable for the requirements. Contribute up to $6,000 per year (as early as possible) to start earning compound interest and save for retirement.

Roth IRAs are great programs that help a lot of individuals save for retirement, but they are limited. Generally speaking, a 401(k) program has up to a 3.25x higher maximum contribution ceiling per calendar year, but it specifically speaks to those in a different income bracket as well.

Go with whatever works for your current income situation. If you think it could change down the road and you could earn over your tax bracket minimum, just know that you may have to pause your Roth IRA contributions and begin a 401(k) program or SDIRA.

Roth IRA FAQ's

What is the downside of a Roth IRA?

You are exclusively using post-tax money, so you will have already had your taxes taken out of your paycheck. This can be a real bummer for anyone who wants to max it out without having to give more of their annual available cash. 

In the end, it does cost you more upfront, but the main benefits are better than a 401(k), so it works out. You must also wait until at least five years after your initial contribution to take that money out should you need it.

Can you withdrawal money out of a Roth IRA at any time?

The beauty of a Roth IRA is that you can take money out whenever you need (post five-years from its inception) and it’s completely tax-free and penalty-free.

These are subject to penalties by the Roth IRA company, so you may incur fees labeled as an early withdrawal if you don’t wait the five years.

Typically, if you have a six-year-old Roth IRA and deposited $5,000 that first year, that’s the money that would be available. Any contributions in the last 5 years have to mature.

Should I max out my Roth IRA at the beginning of the year?

Roth IRAs compound interest and make you money. That’s the entire point. The earlier in the year that you max out your Roth IRA, the more time that money has to grow.

If you contribute $500 in January, you’re only getting interest on that money when February hits. Then you deposit another $500. That’s great, but $500 of your investment so far is going to mature for less time.

Invest as much as you can early on in the year to maximize your return down the line.

Is a Roth IRA or 401(k) better?

Roth IRAs are fantastic for growth, but a 401(k) is better if you aren’t anticipating retirement in a wealthy manner.

Since the money in your 401(k) is taxed when you take it out, you may be taxed at a higher rate (which would be so counterintuitive) if you retire in a higher income bracket than when you began investing in it. 

A Roth IRA makes sense for the long haul if you have plans to open a business, go to college, or increase your personal income by a substantial amount.

Betterment

Explore Betterment's IRA account offerings, including Roth and traditional IRAs, and how they fit into your larger retirement plan.

About the author 

Donny Gamble

I’m Donny. I’m a world traveler, investor, entrepreneur, and online marketing aficionado who has a big appetite to compete and disrupt big markets. I thrive on being able to create things that impact change, difficult challenges, and being able to add value in negative situations.

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