Some people prefer to save for retirement in a traditional individual retirement account (IRA) because of the upfront tax break on contributions. Roth IRAs don’t give you that same tax break on the money you put into your account.
Rather, Roth IRAs are funded with after-tax dollars. But unlike traditional IRAs, you never have to pay taxes on investment gains with a Roth IRA. And withdrawals from a Roth IRA are tax-free, too. That’s huge because many retirees find that money is tighter once they’re on a fixed income, so getting to keep every penny you withdraw could make your financial situation a lot less stressful.
But if you’re interested in investing with a Roth IRA, it’s important to be aware of how these accounts work. Here are three rules to keep on your radar.
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1. You need earned income to fund a Roth IRA
The fact that Roth IRAs let you grow your money tax-free is a beautiful thing. Let’s say you contribute $10,000 to a Roth IRA that grows into $110,000 over time. That means you get to walk away with a $100,000 gain without paying the IRS a dime of it.
However, you should know that you need to have earned income to fund a Roth IRA. You can’t, for example, put your Christmas money into one of these accounts as a teenager and start growing tax-free wealth. You can, however, put earnings from a summertime job into a Roth IRA, up to the allowable limit set by the IRS each year. In 2024, that limit is $7,000 if you’re under age 50 or $8,000 if you’re 50 or older.
2. There are no age limits for Roth IRA contributions
You might think that once you reach retirement age, Roth IRA contributions are off the table. But not so. There are no age limits for funding a Roth IRA, so as long as you meet the earned income requirement, you can contribute to one of these accounts in your 80s if you do choose to do so.
To be clear, though, Social Security benefits do not count as earned income for the purpose of funding an IRA — Roth or traditional. But if you collect those benefits while holding down a part-time job, you can contribute your job-related earnings up to the annual allowable limit.
3. You can remove Roth IRA funds early without a penalty — but you may be taxed on the gains portion of your account
As mentioned earlier, Roth IRAs do not give you a tax break on the money you put in. Because of this, the IRS won’t tax or penalize you for removing your principal contributions prior to age 59 1/2. With a traditional IRA, funds removed prior to age 59 1/2 generally trigger an early withdrawal penalty.
However, if you remove Roth IRA funds before age 59 1/2, you may be subject to taxes on the gains portion of your account (not the principal) if your account is less than five years old. So you’ll need to manage your early withdrawals carefully.
Of course, it’s a good idea to try to leave your Roth IRA funds intact until retirement so you’re not shorting yourself on money you might need later in life. But if an emergency expense pops up, you have the option to remove Roth IRA funds early without automatic penalties.
Roth IRAs are an extremely useful and flexible retirement savings tool. If you’re interested in using one, spend some time reading the rules so you can make the most of your account.
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