What Is a Roth IRA?

What Is a Roth IRA?

Let me explain what a Roth IRA is directly: it's a tax-advantaged individual retirement account where you contribute after-tax dollars for your retirement savings. The IRS calls it an individual retirement arrangement, and its main advantage is that both your contributions and the earnings grow tax-free, with withdrawals also tax-free after you turn 59½, provided the account has been open for at least five years. Essentially, you pay taxes upfront on the money you put in, and then everything comes out tax-free later. Keep in mind that features can differ between providers, so you should compare options before choosing one.

Roth IRAs are like traditional IRAs in many ways, but the key difference is in taxation. You fund a Roth with money you've already taxed, so there's no deduction for contributions, but your withdrawals in retirement are tax-free.

Key Takeaways

Here's what you need to know upfront: A Roth IRA uses after-tax dollars, so growth and qualified withdrawals after age 59½ and five years are tax-free. You can pull out your contributions anytime without taxes or penalties, even if you haven't met the age or time requirements. This makes Roth IRAs ideal if you think your tax rate will be higher in retirement than it is now. For 2024, single filers can't contribute if their MAGI exceeds $161,000, rising to $165,000 in 2025, and for married couples filing jointly, it's $240,000 in 2024 and $246,000 in 2025. In 2025, you can contribute up to $7,000, or $8,000 if you're 50 or older, with phaseouts based on income. Plus, there are no required minimum distributions during your lifetime, which helps with passing wealth to heirs.

How Does a Roth IRA Work?

You put money you've already paid taxes on into a Roth IRA, and when you withdraw earnings in retirement—at age 59½ or later, after holding the account for five years—you avoid further taxes. Contributions can be withdrawn anytime without tax or penalty. You can fund it from sources like regular contributions, spousal contributions, transfers, rollovers, or conversions. All must be in cash, not securities or property, and the IRS sets annual limits that match traditional IRAs—applying across all your IRAs combined.

Your investments grow tax-free, and unlike other plans, you can keep the Roth IRA open indefinitely without required distributions in your lifetime. Traditional IRAs, by contrast, use pretax dollars, giving you a deduction now but taxing withdrawals later.

Allowable Investments in a Roth IRA

Once you've funded your Roth IRA, you can invest in mutual funds, stocks, bonds, ETFs, CDs, or money market funds. Prohibited items include life insurance, collectibles, most coins, and S-corp stock, but you can invest in cryptocurrency, as there's no rule against it. For the widest options, go for a self-directed Roth IRA, where you manage investments yourself, opening up alternatives like digital assets, gold, real estate, partnerships, tax liens, or even franchises.

Be cautious with crypto: in a traditional IRA, gains could face high taxes and penalties if withdrawn early, but in a Roth, following rules means tax-free distributions, which could be a big win if values soar. Remember, you must contribute cash first, then buy crypto inside the IRA, and not all custodians allow it—many stick to standard investments.

Opening a Roth IRA

You can open a Roth IRA at IRS-approved institutions like banks, brokerages, credit unions, or savings associations—often with brokers. Set it up anytime, but contributions for a tax year are due by the next April 15. You'll get an IRA disclosure statement and adoption agreement explaining rules and the custodian relationship. Providers vary in fees, investment options, and requirements, so match them to your risk tolerance and trading style. Some have minimum balances or inactivity fees, and self-directed ones need specialized custodians for non-standard assets.

Are Roth IRAs Insured?

If your Roth IRA is at a bank, FDIC insures up to $250,000, but IRAs are separate from regular deposits, and balances across IRA types combine. For instance, a $200,000 traditional IRA CD and $100,000 Roth IRA savings at the same bank leave $50,000 uninsured.

What Can You Contribute to a Roth IRA?

You can only contribute earned income, like wages, salaries, commissions, or self-employment net earnings after deductions. Divorce-related alimony from pre-2019 settlements qualifies too. Ineligible sources include rental income, interest, pensions, dividends, or passive partnership income. Contributions can't exceed your earned income or the annual limit, and there's no deduction, though you might get a Saver's Tax Credit based on income.

Who’s Eligible for a Roth IRA?

Anyone with earned income can contribute if their MAGI fits the limits, which phase out at higher incomes. For 2025, full contributions for married joint filers under $236,000, partial up to $246,000; for singles under $150,000, partial up to $165,000; separate filers with spouse have tighter rules. Calculate your allowed percentage if in the phaseout.

The Spousal Roth IRA

You can contribute to a spousal Roth IRA for a low- or no-income spouse if married filing jointly, with eligible compensation, and total contributions not exceeding joint income. It's separate from your own IRA, doubling family savings within limits.

Withdrawals: Qualified Distributions

Withdraw contributions anytime tax- and penalty-free. For earnings to qualify tax-free, it's after five years from first funding and one of: age 59½, first home up to $10,000 lifetime, disability, or death to beneficiary.

The Five-Year Rule

If you meet the five-year rule: Under 59½, earnings taxable with penalties unless exceptions like first home or disability; 59½+, no taxes or penalties. If not: Under 59½, taxable with penalties, avoidable for certain expenses; 59½+, taxable but no penalties. Withdrawals are FIFO, so contributions come out first.

Withdrawals: Non-Qualified Distributions

Non-qualified earnings may face taxes and 10% penalty, but exceptions include medical expenses over 7.5% AGI, job loss insurance, education, or up to $5,000 for birth/adoption. Current-year contributions plus earnings can be withdrawn as reversal, with earnings taxed.

Roth IRA vs. Traditional IRA

Choose based on your current vs. retirement tax bracket: Roth suits higher future rates for tax-free income, especially for young or low-income savers leveraging compounding. No RMDs mean better inheritance; beneficiaries stretch distributions tax-free. Traditional offers upfront deductions but taxed withdrawals.

Frequently Asked Questions

On Roth vs. 401(k): Roth offers diverse investments and tax-free withdrawals but no match; 401(k)s have higher limits and possible matches but fees and RMDs. Monthly Roth cap equates to about $583-$667 for 2025. Advantages: flexibility, tax-free growth; disadvantages: no upfront break, lower limits.

The Bottom Line

A Roth IRA lets you withdraw tax-free after 59½ and five years, funded post-tax, ideal if expecting higher retirement taxes. Diversify with other accounts for tax flexibility, as rules can change.