What is a Roth IRA, and How Does It Work?

InvestingIRAs

Oct 8

In a world filled with diverse investment options to fund your retirement, countless choices can help you reach your goals including 401(k) accounts, health savings accounts (HSAs), EFTs, and even real estate. Each of these are smart options, depending on your own unique situation. Today, we’ll cover another retirement investment avenue—Roth IRAs—to help you decide if this path is right for you.

What is a Roth IRA?

A Roth IRA is an individual retirement account intended to help fund your retirement. You contribute after-tax money into the account, with both your contributions and earnings on the account growing tax-free.

How does a Roth IRA work?

After opening a Roth IRA, you can invest in many different types of assets within the account including CDs, stocks, bonds, ETFs, index funds, and mutual funds and withdraw contributions at any time in the absence of taxes or penalties. You can also withdraw from the earnings portion of the account tax-free and penalty-free after you turn 59½ and have held the account for at least five years.

Types of Roth IRAs

Roth IRAs come in a variety of forms including…

Spousal Roth IRAs

A spousal IRA isn’t a special type of account and in fact just your typical Roth or traditional IRA with the same set of rules but opened by your spouse, in his or her name, with a few distinct eligibility requirements.

Rollover Roth IRAs

A rollover Roth IRA is an individual retirement account used to move funds from an employer-sponsored retirement account such as a 401(k), 403(b), or profit-sharing plan.

Inherited Roth IRAs

An inherited Roth IRA is a type of Roth IRA passed down to a beneficiary after the original account owner’s death.

Custodial Roth IRAs

A custodial Roth IRA is a retirement account held by a minor and managed by an adult custodian until the minor reaches legal adulthood.

Roth IRA advantages

Some of the largest benefits accompanying a Roth IRA include…

Tax breaks in retirement

Your money grows tax-free, and you can make tax and penalty-free withdrawals after turning 59½ (provided you’ve held the account for at least five years).

Tax diversification

As it’s nearly impossible to predict what your tax bracket will look like during retirement, tax breaks accompanying a Roth IRA help you diversify your retirement income via both tax-deferred and tax-free accounts.

Wealth transfer

A Roth IRA is also sometimes an excellent wealth-transfer vehicle, allowing you to pass on any amount to your heirs—tax-free!

Flexibility

The ability to withdraw contributions at any time tax- and penalty-free is sometimes beneficial if you’re struggling to make ends meet or need the funds to cover a temporary expense.

No RMDs

Required minimum distributions (RMDs), meanwhile, reflect the amount of money the IRS dictates you must withdraw from your account. Unlike its traditional IRA counterpart, a Roth IRA isn’t subject to any RMD rules—meaning you don’t need to make withdrawals at any point during your lifetime.

Roth IRA disadvantages

As with any investment, Roth IRAs also come with a few drawbacks including…

Five-year wait to withdraw earnings

Withdraw from the earnings portion of your Roth IRA before you turn 59½ or hold the account for less than five years, and you may face a 10% early-withdrawal penalty and the need to pay taxes on these earnings.

Income limits

If you earn more than the allowed amount, you may not qualify for a Roth IRA (see below for details).

No upfront tax break

Unlike with 401(k)s and traditional IRAs, Roth IRAs don’t feature an upfront tax break.

Roth IRA eligibility rules

Though you can contribute to a traditional IRA regardless of how much money you earn, this isn’t the case with Roth IRAs—which boast much stricter income limits.

For example, if you’re a single filer with a modified adjusted gross income (MAGI) exceeding $165,000 in 2025, you’re not eligible to contribute to a Roth IRA. Moreover, if your MAGI is more than $150,000 but less than $165,000, you can only contribute a reduced amount. Those who earn $150,000 or less in 2025, meanwhile, can do so for the full amount.

For those filing jointly, the maximum MAGI limit is $246,000 based on contribution qualifications. If your joint MAGI is more than $236,000 but less than $246,000, your maximum allowed annual contribution is reduced. Finally, couples earning less than $236,000 can contribute the full amount.

If you’re a higher-income earner (exceeding these income thresholds), you can still contribute to a Roth IRA but must do so through an IRS-approved method referred to as a “backdoor IRA.” There are several approaches here, each of which requires converting a portion of (or all) traditional IRA funds to a Roth.

Roth IRA contribution limits

As with many retirement accounts, you’ll need to adhere to several Roth IRA rules. One such example is contribution limits, meaning you can’t just add any amount of money to the account. Roth IRAs feature the same contribution limits as traditional IRAs; those under 50 years of age have a maximum annual contribution limit of $7,000, which climbs to $8,000 once you hit age 50 for 2025 (limits do change annually). The extra $1,000 for this older age group is referred to as a “catch-up” contribution, offered by the IRS to encourage savings and help ease the financial burden of retirement—especially for those who failed to save enough when they were younger. This amount is likely tweaked annually to accommodate cost-of-living adjustments, and you can also continue to make contributions for the previous year up until the income tax deadline (e.g., any amount up to the limit until April 15, 2026 for 2025).

Roth five-year rule for withdrawals

The Roth IRA 5-year rule essentially states when you’re allowed to make withdrawals without the burden of penalties or taxes, specifically that you can’t withdraw from the earnings portion of an IRA unless at least five years have passed since you made your initial contribution to the account. Withdrawing earnings prior to this (or before turning 59½) can trigger taxes and penalties including:

Income taxes on the earnings portion of the withdrawal
A 10% penalty unless you qualify for an exception

There are exceptions to every rule, however, and Roth IRAs are no different. For example, anyone who’s owned a Roth IRA for more than five years and is younger than 59½ can often avoid early-withdrawal penalties and taxes in various situations including:

· Using the withdrawal to fund a first-time home purchase (up to $10,000)

· Having your estate or beneficiary withdraw the money after your death (if you’ve held the account for less than five years)

If you’ve had your Roth IRA for less than five years and are younger than 59½, you can avoid the early-withdrawal penalty (but are still subject to taxes) if:

· You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.

· You use the withdrawal to pay for qualified education expenses.

· You use the withdrawal to fund a first-time home purchase (up to $10,000).

· You use funds for qualified expenses related to a birth or adoption.

· Your estate or beneficiary withdraws the money after your death (if you’ve held the account for less than five years).

· You make the distribution in substantially equal periodic payments (otherwise known as a “SEPP”).

Note the SECURE Act 2.0 has expanded these circumstances to include emergency expenses and domestic abuse.

How to open a Roth IRA

You can open a Roth IRA at almost any bank, credit union, or other financial institution, with the former two options most likely taking shape as an IRA certificate of deposit (CD)—often a good option for people who want to minimize risk and guarantee their return. You can also do so through your financial advisor or online brokerage, thus enjoying the ability to choose your investments and potentially see higher returns (albeit with more risk).

How to contribute to a Roth IRA

You generally need earned income—such as income earned through your job—to contribute to a Roth IRA, though additional options include through a 401(k) rollover, Roth conversion, or spousal contribution.

Roth vs. traditional IRAs

The biggest difference between a Roth and traditional IRA is in their tax treatment. With the former, contributions are made using after-tax money that can then grow tax-free, and you won’t pay taxes on withdrawals made during retirement—assuming the account is at least five years old. A traditional IRA, on the other hand, is a tax-deferred account so you’ll pay taxes on a future date. These contributions are typically funded with pre-tax dollars, and earnings grow tax-deferred until they’re withdrawn in retirement. 

In sum: choosing a Roth IRA

How can you determine if a Roth IRA is right for you? Generally speaking, this option makes the most sense if you want more flexibility in withdrawing funds (contributions) in the absence of penalties, don’t want to worry about RMDs during retirement, and/or want to diversify your retirement savings so you can draw from both tax-free and taxable accounts.

Have questions about how a Roth IRA fits into your overall investment strategy? Schedule a FREE discovery call with one of our financial advisors to get them answered.

What people also ask

The specific amount varies depending on the provider you choose. While many have no minimum requirement—allowing you to open an IRA with as little as $0—how much you should contribute to your IRA ultimately depends on your own unique financial situation and goals.
As with any investment, this is in fact possible due to market volatility, poor investment decisions, early withdrawal and investment fees, or a combination of these.
As with traditional IRAs, you are prohibited from using your Roth IRA to take out a loan—unlike other retirement vehicles such as 401(k)s.
A mega backdoor Roth strategy allows you to contribute significantly more to your retirement plan and thus add thousands of extra dollars to your fund.
Roth IRA heirs must generally follow the same rules as those who inherit a traditional IRA, meaning designated beneficiaries—those who aren’t a spouse, minor child of the deceased owner, chronically ill or disabled, or more than 10 years younger than the account owner—must follow the 10-year rule that requires heirs to withdraw funds from the inherited account within 10 years of the IRA owner’s death (e.g., if a Roth IRA owner passes away in 2025, inherited IRA funds must be fully distributed by December 31, 2035).
If you’re the sole beneficiary of your spouse’s Roth IRA, click here to check out your options in this regard.
Contributions in excess of annual Roth limits can trigger a penalty from the IRS, but you are allowed to backtrack. If you’ve already filed, you can remove the excess and earnings within six months and file an amended tax return; those who haven’t already filed can withdraw the excess contributions and earnings received on them. Either scenario requires you to pay taxes on earnings, but you won’t encounter a penalty. Another option is to reduce the following year’s contribution by the excess, but you’ll pay a 6% penalty on this amount for every year it remains in the account.
Due to the SECURE Act 2.0, individuals older than 70½ can now continue making IRA account contributions provided they’ve earned income. The impetus behind this measure is to incentivize those working later in life to save additional money and continue to build their nest egg over a longer period of time.
Prohibited investments include collectibles, life insurance, S-Corp stock, and coins not minted by the U.S. Treasury.
Ideally, you should contribute to both rather than choose between a 401(k) and Roth IRA as doing so will provide tax diversification in retirement.