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How Does a Roth IRA Work?

A Roth IRA gives investors a "pay now, save later" tax advantage, unlike 401(k) or traditional IRAs, which tax withdrawals in retirement.
Jan. 10, 2018
Investing, IRA, Roth IRA
how-a-roth-ira-works
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The Roth IRA is about delayed gratification: Unlike other individual retirement accounts, with a Roth IRA you pay taxes on your contributions every year. But also unlike other individual retirement accounts, with a Roth you pay no taxes on distributions — including your investment growth — when you reach retirement age.

Roth IRAs also allow you to withdraw contributions at any time without a penalty. That makes Roth IRAs a good tool not only for retirement savings, but also for goals such as saving for college or a down payment on a house.

You can even tap them in the case of financial emergencies, though we recommend against draining retirement savings during your working years unless it’s absolutely necessary.

How Roth IRAs are different

The Roth IRA, like a traditional IRA, builds savings by allowing its owner to make regular contributions and invest them in a portfolio of stocks, bonds, mutual funds or other investments.

Unlike the alphabet soup of other retirement account names, such as IRA, SIMPLE IRA, 401(k) and 403(b), the Roth IRA is named after a real human being: Sen. William Roth, who 20 years ago led the creation of this unique retirement plan.

“Bill wanted to create a culture of savings,” his widow, Judge Jane Roth of the 3rd U.S. Circuit Court of Appeals, told NerdWallet in a conversation in 2016. “He realized how important and how difficult it was for people to save money for higher education and retirement. One of his aims was to find incentives and methods and to help with that.”

With the Roth IRA, the reward for paying more taxes now is a heftier tax savings down the line as your investments grow. As this Roth IRA calculator shows, a 35-year-old with an $80,000 annual income who contributes the full $5,500 limit to a Roth IRA until retiring at 67 could end up with $518,000 in savings (assuming a 6% annual return).

But unlike a traditional IRA, all those post-retirement withdrawals would be tax-free, offering a savings of more than $130,000 in retirement. (Fans of traditional IRAs, however, might note that those accounts could offer tax benefits throughout the saver’s working years that a Roth could not.)

Limitations of the Roth

The tax savings are so good, the government restricts the amount Roth IRA holders can contribute to $5,500 a year ($6,500 if you are 50 or older). IRS rules also limit who qualifies for a Roth: High earners may be restricted from contributing the full $5,500 each year — or even from contributing at all, as the table below shows.

Roth IRA contribution limits for 2017-2018

Filing status2017 modified AGI*2018 modified AGI*Maximum contribution
*Adjusted gross income
Married filing jointly or qualifying widow(er)Less than $186,000Less than $189,000$5,500 ($6,500 if 50 or older)
$186,000 to $195,999$189,000 to $198,999Contribution is reduced
$196,000 or more$199,000 or moreNot eligible
Single, head of household or married filing separately (if you did not live with spouse during the year)Less than $118,000Less than $120,000$5,500 ($6,500 if 50 or older)
$118,000 to $132,999$120,000 to $134,999Contribution is reduced
$133,000 or more$133,000 or moreNot eligible
Married filing separately (if you lived with spouse at any time during the year)Less than $10,000Less than $10,000Contribution is reduced
$10,000 or more$10,000 or moreNot eligible

While the tax-free early-withdrawal feature of the Roth is attractive, it’s important to know that applies only to the amount you’ve contributed to the account, not to any additional money that it’s earned. Any earnings withdrawn from your investments before age 59½ would typically be penalized twice: an initial 10% penalty taken off the top, then the usual tax you’d pay on the additional income (though there are some exceptions).

The ‘pay now, save later’ tax feature is especially appealing if you expect your tax bracket to rise in the years ahead and remain relatively high in your retirement years.

Of course, the longer you avoid withdrawals and make annual contributions to a Roth IRA, the more cash you’ll potentially accrue, and the greater tax savings you’ll likely have down the line. The “pay now, save later” tax feature is especially appealing if you expect your tax bracket to rise in the years ahead and remain relatively high in your retirement years.

Getting started with a Roth IRA

Most online brokers, banks and robo-advisors offer Roth IRAs. When shopping for the right provider, a good first question to ask yourself is whether you might prefer a hands-off, “please do it for me” approach to investing. If so, you might lean toward a robo-advisor and its automated investment process, which uses your goals and risk tolerance to pick your investments.

If you want to choose your own investments — or learn how to do so — then an online brokerage firm may be the right place to start. You’ll want to look for a broker with a user-friendly platform and a wide range of low-cost investment choices. You may also wish to choose a broker with a branch network near you if you desire face-to-face help. You can review NerdWallet’s analysis of the best Roth IRA providers to see this year’s top picks.

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