As an alternative to corporate 401(k) and traditional IRAs, Roth IRAs have become a popular option for those who want to build a nest egg for their later years.

Unlike other retirement accounts, Roth IRAs are funded with after-tax dollars, so when you reach retirement age, you can use the money without paying more taxes, this includes capital gains tax. 

The Roth IRA: Defined

A Roth IRA is an individual retirement account funded with after-tax income. It was introduced in 1997 as part of the Taxpayer Relief Act.

Traditional IRAs are funded with pre-tax dollars, and when you reach 70 ½ and start to withdraw funds, you pay taxes on what you withdraw. The theory is that you are in a lower tax bracket and can keep more of your proceeds.

The Roth IRA is the opposite as far as income taxes are concerned. Roth IRAs are funded with post-tax dollars, and you do not pay taxes when you withdraw the funds. There are some rules to follow regarding withdrawal age and the time your money has been in the IRA.

How Do You Set Up a Roth IRA?

A Roth IRA can be set up online or by heading to a financial institution to set it up in person. They will want basic information such as your name, address, date of birth, social security number, and employment information.

Then you will need to start depositing funds and decide on an investment strategy. Pay attention to how your money is growing, adjust your portfolio as needed, and you are on your way.

How Much Can You Contribute to a Roth IRA?

If you are under 50 years old, you may contribute up to $6,000 for 2022 ($6,500 for 2023). If you are 50 or older, you can contribute an extra $1,000. This is called a catch-up contribution and allows you to grow the account a little faster as you approach retirement age.

If you contribute to both a traditional and Roth IRA, the contribution limits for the two must not exceed the yearly limit. Other than that, you can split the contributions up however you like. 

Both traditional and Roth IRAs require you to earn compensation to contribute. The IRS lists what qualifies as compensation. The list includes wages, salaries, commissions, self-employment income, taxable alimony, and non-taxable combat pay.

Income from real estate, pensions, annuities, and non-income-producing partnerships, Conservation Reserve Programs, foreign-earned income, and deferred compensation cannot be counted as compensation.

It’s not enough to earn compensation, but the compensation must be equal to or greater than the amount you use to fund your IRA. In other words, you must make at least $6,000 to contribute $6,000 to your Roth IRA.

You can make a spousal IRA contribution for your non-working spouse that does not work. 

Roth IRAs limit contributions based on modified adjusted gross income (AGI). AGI is your gross income minus tax deductions. In 2022, the modified AGI limit for a single person is $129,000, and the limit for a married person filing jointly is $204,000.

For 2023, the limits will rise to $138,000 and $218,000, respectively.

If your modified AGI is between $129,000 and $144,000 as a single person or between $204,000 and $214,000 as a married person filing jointly, you can still contribute to a Roth IRA, but your contribution limits are reduced. These thresholds will also rise in 2023.

Typically, a person contributes to a retirement account in their younger years and starts withdrawing funds when they reach retirement age (or stop working).

While you must wait until 59 ½ to start withdrawing funds, there is no age limit when you must stop contributing to a Roth IRA.

The only limit is the compensation we just mentioned. So, if you are 80 and still working in some capacity and earning income, you can still put money in your Roth.

Tax Differences Between Roth and Traditional IRAs

The main difference between traditional and Roth IRAs is when you pay income taxes. Traditional IRAs are funded before you pay income tax in the year you contribute to the fund. They lower your tax burden in the current year. Taxes are paid when you start your withdrawals. 

Traditional IRAs allow you to deduct your contributions to your taxes in the year the contribution is made.

How much you can deduct depends on whether you have an IRA in addition to an employer-sponsored retirement program and whether your modified AGI exceeds the income thresholds. IRS Publication 590-A will help determine how much you can deduct.

Roth IRAs are funded with post-tax dollars and are not deductible on your tax returns. When you reach 59 ½, and as long as you have had the funds in your investment account for five years, you can withdraw your money tax-free.

Do You Pay Capital Gains in a Roth IRA?

Neither Roth nor traditional IRA disbursements are subject to capital gains taxes if you follow a few simple rules.

First, you must hold the Roth funds in your account for at least five years.

Second, you wait until you are 59 ½ to withdraw any funds.

In short, Roth IRAs are never subject to short or long-term capital gains. You may, however, be subject to tax if you withdraw your proceeds before you turn the required age and before that five-year threshold. 

If you meet the two requirements and your money grows in your investment account, you will not be taxed on your initial investment or profit.

How Capital Gains Taxes Work

Even though capital gains taxes are not imposed on Roth or traditional IRAs, it helps to know how they work. You will see the difference between investing in a Roth IRA versus the typical funding of an investment account.

When you invest your money in an account, you do it with the hope that it will grow. Let’s say you put $5,000 into a security and leave it there for ten years.

Ideally, after ten years, it will hopefully be worth more. Let’s assume that the same investment is worth $7,500. You’ve realized a profit of $2,500. Capital gains taxes are often imposed on that $2,500 profit.

The good news is that these gains are not typically taxed until you decide to cash them out. As long as they sit in the investment account, you do not have to pay taxes on them.

Securities do have a degree of risk involved. Putting $5,000 in an account could pay off grandly in the long term or lose value. This depends on the volatility of the market as well as the risk of your investments. 

Long-term capital gains rates range from 0% to 20% depending on your filing status and the amount of gain. Gains on collectibles are higher. People who buy and sell real estate may be charged capital gains if the money is not reinvested within a certain period of time.

It’s often a matter of timing. When you retire and withdraw money from investments, your income, in theory, is lower than when you were working full-time. This might put you under the threshold where you would not even get charged capital gains taxes.

But we’ve already established that Roth IRAs are not subject to capital gains tax, which makes them attractive investments. The same investment outside an IRA is subject to taxes, but because it’s part of a Roth, you can withdraw it tax-free.

Furthermore, If your investment gains value over time, you are not taxed on your withdrawals. 

How Roth IRA Withdrawals Are Taxed

Roth IRA withdrawals are tax-free as long as you are 59 ½ and have held the security for at least five years. Penalties are imposed if you withdraw your funds early, except if the withdrawal has a specific purpose.

Here is a summary of how taxes work at different withdrawal ages.

Age 59 and Under

If you withdraw your money before you reach age 59 ½, you will be charged a 10% early withdrawal penalty. There are exceptions to this rule, which we’ll talk about in a moment.

Over Age 59 ½

You can withdraw your money tax and penalty-free if you’ve held your investment for five years. With other retirement accounts, there are mandatory withdrawals when you reach a certain age. The Roth IRA has no such rules.

In fact, there is no requirement that you ever withdraw your money. You can leave it in the account and pass it on to a beneficiary. The catch is that the beneficiary must be 59 ½ to withdraw the money free of penalties. 

For All Ages

Roth IRAs offer some other advantages for an individual, regardless of their age. You can withdraw money early to buy your first house, pay for higher education, collect disability, pay for medical costs, or if you incur financial hardship. Penalties are waived for these withdrawals. 

With any long-term investment, the sooner you start your Roth IRA contributions or any retirement account, the more time your money has to grow. A few thousand dollars invested in your twenties or thirties could compound into a nice nest egg by the time you are 59 ½.

What Investments Do Roth IRAs Allow?

You can choose what types of investments to include in your Roth IRA.

Since you will be holding the investment for at least five years, and probably longer depending on your age, you will want to take a long-term approach to investing, meaning that your investment will need to weather the ups and downs of the market. 

Your investment strategy should be diverse—a mixture of stocks and bonds that will grow steadily and make you money long-term. Your mix between stocks and bonds depends on your age.

Younger investors have a longer period of time before they will take withdrawals. As a result, they can lean heavily on stock funds that are higher risk and have higher income potential. Older investors tend to lean toward less risky bond funds.

Either way, it’s wise to have both types of funds.

Here are some typical fund options:

  1. US Stock Index Funds are based on the total market or S&P 500 funds. The total market funds focus on small-cap and mid-cap stocks, whereas the S&P 500 funds focus on large-cap stocks. These funds tend to be more volatile than some as they are based on the movement of the stock market. However, they will generally grow your money faster than bond funds. Index funds often have lower costs as the fund managers are not trying to actively beat the market.
  2. US Bond Index Funds are a more stable investment. One bond fund that tends to be less risky is an aggregate bond index fund, a mix of treasury bonds, corporate bonds, and other debt securities. Even if you are young and leaning toward stocks and riskier investments, you will want some percentage of bonds in your portfolio.
  3. Global Stock Index Funds hold foreign stocks (non-US companies). Some global funds focus on emerging market economies such as China or Brazil and may be more volatile than those focused on stable countries such as France or Germany. Because there is more risk associated with global funds, your growth potential is higher. Adding a global stock index fund can add diversity to your portfolio. 

Another strategy to consider is opening more than one Roth IRA account.

While there are limits on how much you can contribute to IRA accounts in a given year, nothing is stopping you from putting money in a few different accounts and adjusting the investment strategy.

Perhaps you have one account that is more heavily invested in stocks and one more heavily invested in bonds. A financial advisor can help with these decisions.

The Bottom Line

Saving for retirement allows you to stop working at a certain point and pursue a different path. Any retirement account will get you to that point. If you work at a corporate job, contribute to a 401(k) plan. If that is not available, a traditional IRA is an option.

But depending on when you want to pay your taxes, adding a Roth IRA to your portfolio is wise. Add money to your account now with after-tax dollars and enjoy freedom from taxes when you are older.

We have plenty of resources and tools. Check them out here. 

About the Author Tiffany Aliche

Tiffany “The Budgetnista” Aliche, is an award-winning teacher of financial education, America’s favorite, personal financial educator, and author of the New York Times Bestselling book, Get Good with Money. The Budgetnista is also an Amazon #1 bestselling author of The One Week Budget and the Live Richer Challenge series and most recently, a children's book, Happy Birthday Mali More.

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