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What is Roth IRA and what makes it unique?

A Roth IRA is a type of individual retirement account allowing someone to set aside after-tax income for retirement. So you pay income tax on funds you put into your Roth IRA but don't pay any tax on qualified withdrawals.

This is the opposite of a traditional IRA. With a traditional IRA, you pay tax on the withdrawals in retirement but not on contributions today. Because of their unique structure, Roth IRAs are best for younger investors with a long time horizon to retirement. Those of us who are closer to retirement usually get a better deal with a traditional IRA.

A Roth IRA is a type of brokerage account you can open with any major investment company and some banks. Just like a regular brokerage account, you can buy and sell exchange-traded funds (ETFs), mutual funds, stocks, bonds, and other assets. But unlike a regular investment account, you won't pay tax on profits when you withdraw as long as you follow IRS rules.

Roth contribution tax savings

Be sure to track your Roth contribution history. You are allowed to withdraw contributions anytime with no taxes or penalties. But the earnings on your contributions are a different story.

If you withdraw earnings from a Roth IRA before retirement, you may have to pay income tax plus a 10% penalty. That's why it is so important to leave your funds in the account until you reach age 59½, an age set by the IRS for retirement account withdrawals.

There are a few exceptions. You can withdraw up to $10,000 for a first-time home purchase without penalties but do have to pay tax. Using Roth IRA funds for qualified education expenses is also allowed.

There are a few other, less common allowed early withdrawals, including disability and paying for medical expenses.

When to make a Roth contribution

When I had a regular day job with 26 biweekly paychecks, I divided the total allowed annual Roth IRA contribution evenly across all paychecks. For someone who gets paid on the same schedule and wants to contribute the maximum $6,500 per year (the limit for 2023), that would be $250 per paycheck.

You can contribute at any time, however. As someone who is now self-employed, I make a lump contribution for the entire balance once per year. You can divide it up any way you choose. But remember that investing in your Roth IRA (or traditional IRA) on a regular basis is an important part of saving for retirement.

Contributions are allowed into the following year until tax day. For 2022, for example, you can make contributions through April 15, 2023. But you have to get the contribution in before you file your tax return.

Who does a Roth IRA best for?

Roth IRA is generally best for people who are in lower-income tax brackets during their earning years than they expect to be during their retirement years. The idea is to pay the tax while you are in the lowest possible tax bracket.

A Roth is also a good idea for people who don't have access to a retirement plan through work. Only 50% of Americans have access to a 401(k) plan. A Roth is a great way to jumpstart your retirement savings, especially if you start investing at a young age.

Since the Roth IRA rules around withdrawals are more forgiving than other retirement accounts (for both early and regular withdrawals), a Roth can also act as an absolute last-ditch emergency fund. Generally, the advice from financial advisors and experts is never to withdraw money from retirement accounts before you need it. And that's good advice. But if something terrible befalls your finances, it is easier to get money out of a Roth IRA than other accounts.

Why you should consider a Roth IRA

Roth IRAs are great for most middle-class earners for a few reasons:

  • The maximum isn’t crazy high. The annual maximum contribution limit of $6,500 is just large enough to add up quickly over time but just small enough that — with some adjustments — most people can hit it.
  • No taxes in retirement. Most people like the Roth because you pay the taxes upfront. So when it comes to your retirement years, you don’t have to worry about any taxes. The money you’ve saved in your account is 100% yours.
  • This sure makes figuring out your retirement budget easy — you won’t need to worry about accounting for Uncle Sam’s cut. And knowing you can simply withdraw the money without having to fill out any more tax paperwork can be a load off your mind, as well.
  • Easy to open. A Roth IRA is a basic retirement account you can find practically anywhere. Brokerages, companies, banks and credit unions offer these accounts. They’re very common, which means, for most people, they’re easy to open.
  • In fact, you can even open up a Roth IRA online. I’ve opened two of these accounts, both entirely over the internet.

Advantages of investing in a Roth IRA

You can withdraw your funds from a Roth IRA tax-free at any time if you made your first Roth IRA contribution at least five years ago and are at least 59½ years old. You pay a penalty if you withdraw your money early. But you can take out funds without paying this penalty if:

  • You become disabled.
  • After your death, the distribution is made to a beneficiary of your estate.
  • You or someone in your family uses the money (up to $10,000) to buy a first home.

By allowing for tax-free withdrawals in retirement, a Roth IRA helps account holders diversify their tax base in retirement. Of course, tax rules and regulations change, and they could change in the future. But for now, any contributions made to a Roth IRA can be withdrawn tax-free.

Roth IRAs are also not subject to required minimum distributions. This is a huge benefit if you don't need to withdraw funds from your IRA in retirement.

The SECURE Act passed at the end of 2019 provides advantages when a Roth IRA is passed on to a non-spousal heir. Your heir no longer needs to wait to withdraw the money, as was true prior to the passing of this new law. But the downside is that your heir must withdraw the full amount within ten years.

Try to take full advantage of this unique tax-saving retirement strategy

The first place most people should focus on investing is their 401(k) or similar. Make sure to take 100% advantage of any employer match. Once you reach that level, your traditional and Roth IRAs should be the next priority. If you reach the maximum there, go back to the 401(k) until you reach the limit.

I make sure to contribute the maximum for myself and my wife every year. That is one investment I'm sure we'll never regret.

About the Author

Eric Rosenberg

Eric Rosenberg

Freelance Contributor

Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full time.

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