What is a Roth IRA?

Key Takeaways

● A Roth IRA is a special individual retirement account (IRA) that allows individuals below a certain income ceiling to contribute a fixed amount of money each year.

● Single filers can contribute to a Roth IRA if they earn less than $153,000 in 2023 ($144,000 for 2022). For married couples filing jointly, the limit is $228,000 in 2023 ($214,000 for 2022).

● The main difference between traditional IRAs and Roth IRAs is how the two are taxed.

Understanding a Roth IRA

A Roth IRA is an individual retirement account where you pay taxes on money going into your account, and then all future withdrawals are tax-free.

In 2023, the maximum contribution limit to a Roth IRA is $6,500 for individuals under 50 and $7,500 for those over 50. The maximum modified adjusted gross income limit to be eligible for a Roth IRA is $153,000 for single filers, and $228,000 for joint filers. Roth IRA income and contribution caps are frequently adjusted.

In most cases, you can withdraw your money in retirement without paying additional taxes if you have a Roth IRA instead of a traditional IRA because the former allows you to pay taxes on your income now. The latter requires you to pay taxes when you withdraw your money. However, traditional IRAs are designed to allow contributors to withdraw money when they are older and are typically taxed at a lower rate.

For some investors, particularly those who anticipate moving into a higher tax bracket in the future, Roth IRAs can be advantageous.

Example of How a Roth IRA Works

If a person taxed at 12% today wants to invest $4,000 in a Roth IRA,

she will pay $4,000×12%=$480 in taxes,

leaving her with only $4,000-$480=$3,520 available to invest.

Assuming her investment doubles by the time she wants to begin withdrawing, her account would be worth $3,520×2=$7,040, regardless of what her future tax rate is.

If that same person uses a traditional IRA, her $4,000 is tax-deductible.

Assuming her investment doubles, her account be worth is $4,000×2=$8,000.

However, she has to pay taxes on any amount withdrawn.

If her tax rate is still 12%, the value of her IRA is $8,000-$8,000×12%=$7,040 after taxes.

But if her tax rate is higher (let's assume 22%), regardless of whether it's through tax hikes or higher earnings, her account would only be worth $8,000-$8,000×22%=$6,240 after taxes.

Investors should therefore think about which IRA type is best for them while keeping in mind that future tax implications and personal circumstances can change over time.