What Is a Roth IRA?

A Roth IRA is an individual retirement account (IRA) that allows qualified withdrawals on a tax-free basis provided certain conditions are satisfied. Established in 1997, it was named after William Roth, a former Delaware Senator.﻿﻿ Roth IRAs are similar to traditional IRAs, with the biggest distinction between the two being how they’re taxed. Roth IRAs are funded with after-tax dollars; the contributions are not tax-deductible. But once you start withdrawing funds, the money is tax-free. Conversely, traditional IRA deposits are generally made with pretax dollars; you usually get a tax deduction on your contribution and pay income tax when you withdraw the money from the account during retirement.﻿﻿

This and other key differences make Roth IRAs a better choice than traditional IRAs for some retirement savers.

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

Roth IRAs are best when you think your taxes will be higher in retirement than they are right now.

You can't contribute to a Roth IRA if you make too much money. In 2020, the limit for singles is $139,000. For married couples, the limit is $206,000 ﻿ ﻿.

﻿. The amount you can contribute changes periodically. In 2020, the contribution limit is $6,000 a year unless you are over 50—in which case, you can deposit up to $7,000 ﻿ ﻿.

﻿. Almost all brokerage ﬁrms, both physical and online, offer a Roth IRA. So do most banks and investment companies.

Understanding Roth IRAs

Similar to other qualified retirement plan accounts, the money invested within the Roth IRA grows tax-free. However, a Roth is less restrictive than other accounts in several ways. Contributions can continue to be made at any age, as long as the account holder has earned income.﻿﻿ The account holder can maintain the Roth IRA indefinitely; there are no required minimum distributions (RMDs) during their lifetime, as there is with 401(k)s and traditional IRAs.﻿﻿

A Roth IRA can be funded from a number of sources:

Regular contributions

Spousal IRA contributions

Transfers

Rollover contributions

Conversions

All regular Roth IRA contributions must be made in cash (which includes checks); they can't be in the form of securities or assets. However, a variety of investment options exist within a Roth IRA once the funds are contributed, including mutual funds, stocks, bonds, ETFs, CDs, and money market funds.﻿﻿

The IRS limits how much can be deposited in any type of IRA, adjusting the amounts periodically. The contribution limits are the same for traditional and Roth IRAs.﻿﻿

$6,000 The maximum annual contribution an individual can make in 2019 and 2020 to a Roth IRA. Those 50 years old and up can contribute up to $7,000.﻿﻿

Opening a Roth IRA

A Roth IRA must be established with an institution that has received IRS approval to offer IRAs. These include banks, brokerage companies, federally insured credit unions, and savings and loan associations. Generally, individuals open IRAs with brokers.

A Roth IRA can be established at any time. However, contributions for a tax year must be made by the IRA owner’s tax-filing deadline, which is generally April 15 of the following year. Tax-filing extensions do not apply.﻿﻿

There are two basic documents that must be provided to the IRA owner when an IRA is established:

These provide an explanation of the rules and regulations under which the Roth IRA must operate, and establish an agreement between the IRA owner and the IRA custodian/trustee.

Not all financial institutions are created equal. Some IRA providers have an expansive list of investment options, while others are more restrictive. Almost every institution has a different fee structure for your Roth IRA, which can have a significant impact on your investment returns.

Your risk tolerance and investment preferences are going to play a role in choosing a Roth IRA provider. If you plan on being an active investor and making lots of trades, you want to find a provider that has lower trading costs. Certain providers even charge you an account inactivity fee if you leave your investments alone for too long. Some providers have more diverse stock or exchange-traded fund offerings than others; it all depends on the type of investments you want in your account.

Pay attention to the specific account requirements as well. Some providers have higher minimum account balances than others. If you plan on banking with the same institution, see if your Roth IRA account comes with additional banking products. If you're looking at opening a Roth at a bank or brokerage where you already have an account, see whether existing customers receive any IRA fee discounts.

2:11 Roth IRA Vs. Traditional IRA

Are Roth IRAs Insured?

If your account is located at a bank, be aware IRAs fall under a different insurance category than conventional deposit accounts. Therefore, coverage for IRA accounts is not as robust. The Federal Deposit Insurance Corporation (FDIC) still offers insurance protection up to $250,000 for traditional or Roth IRA accounts, but account balances are combined rather than viewed individually.﻿﻿ ﻿﻿

For example, if the same banking customer has a certificate of deposit held within a traditional IRA with a value of $200,000 and a Roth IRA held in a savings account with a value of $100,000 at the same institution, the account holder has $50,000 of vulnerable assets without FDIC coverage.

What Can You Contribute to a Roth IRA?

The IRS dictates not only how much money you can deposit in a Roth, but the type of money you can deposit. Basically, you can only contribute earned income to a Roth IRA.﻿﻿

For individuals working for an employer, compensation that is eligible to fund a Roth IRA includes wages, salaries, commissions, bonuses, and other amounts paid to the individual for the services they perform. It's generally any amount shown in Box 1 of the individual's Form W-2. For a self-employed individual or a partner in a partnership, compensation is the individual’s net earnings from their business, less any deduction allowed for contributions made to retirement plans on the individual’s behalf and further reduced by 50% of the individual’s self-employment taxes.

Money related to divorce—alimony, child support, or in a settlement—can also be contributed.

So, what sort of funds aren't eligible? The list includes:

Rental income or other profits from property maintenance

Interest income

Pension or annuity income

Stock dividends and capital gains

You can never contribute more to your IRA than you earned in that tax year. And, as previously mentioned, you receive no tax deduction for the contribution—although you may be able to take a Saver's Tax Credit of 10%, 20%, or 50% of the deposit, depending on your income and life situation.﻿﻿

Who's Eligible for a Roth IRA?

Anyone who has taxable income can contribute to a Roth IRA—as long as they meet certain requirements concerning filing status and modified adjusted gross income (MAGI). Those whose annual income is above a certain amount, which the IRS adjusts periodically, become ineligible to contribute.﻿﻿ The chart below shows the figures for 2019 and 2020.