A Roth IRA is an individual retirement account (IRA) under United States law that is generally not taxed upon distribution, provided certain conditions are met. The principal difference between Roth IRAs and most other tax-advantaged retirement plans is that rather than granting an income tax reduction for contributions to the retirement plan, qualified withdrawals from the Roth IRA plan are tax-free, and growth in the account is tax-free.
The Roth IRA was introduced as part of the Taxpayer Relief Act of 1997 and is named for Senator William Roth.
A Roth IRA can be an individual retirement account containing investments in securities, usually common stocks and bonds, often through mutual funds (although other investments, including derivatives, notes, certificates of deposit, and real estate are possible). A Roth IRA can also be an individual retirement annuity, which is an annuity contract or an endowment contract purchased from a life insurance company. As with all IRAs, the Internal Revenue Service mandates specific eligibility and filing status requirements. A Roth IRA's main advantages are its tax structure and the additional flexibility that this tax structure provides. Also, there are fewer restrictions on the investments that can be made in the plan than many other tax-advantaged plans, and this adds somewhat to their popularity, though the investment options available depend on the trustee (or the place where the plan is established).
The total contributions allowed per year to all IRAs is the lesser of one's taxable compensation (which is not the same as adjusted gross income) and the limit amounts as seen below (this total may be split up between any number of traditional and Roth IRAs. In the case of a married couple, each spouse may contribute the amount listed):
Originally introduced as the âÂÂIRA Plus,â the concept behind what would become the Roth IRA was proposed in 1989 by Senators Bob Packwood and William Roth. Their plan (Packwood-Roth plan) allowed individuals to contribute up to $2,000 without receiving an upfront tax deduction; instead, the earnings would grow and be withdrawn tax-free in retirement. This early proposal established the basic logic of the later Roth IRA: paying taxes now in exchange for tax-free income later.
The Roth IRA was ultimately created by the Taxpayer Relief Act of 1997 and named after Senator Roth, its leading sponsor. Its introduction marked a significant shift in federal retirement policy by offering an alternative to traditional IRAs, which had lost their universal deductibility after the 1986 Tax Reform Act. Under congressional budget rules, restoring fully deductible IRAs for all taxpayers would have violated congressional budget limits, lawmakers restricted deductible IRAs to low-income households and provided the Roth IRA as an after-tax option for others. This structure allowed the cost of the tax break to fall largely outside the 10-year budget window, making the bill easier to pass.
While IRAs grew rapidly in the early 2000s, rising to over 50 million account holders and more than $3 trillion in assets by 2007, Roth IRAs represented only a small portion of these balances in the programâÂÂs early years. Their popularity grew gradually as more taxpayers became familiar with the benefits of tax-free withdrawals.
Economists have warned about exploding future revenue losses associated with Roth IRAs. With these accounts, the government is "bringing in more now, but giving up much more in the future," said economist and Forbes contributor Leonard Burman. In a study for The Tax Policy Center, Burman calculated that from 2014 to 2046, the Treasury would lose a total of $14 billion as a result of IRA-related provisions in the 2006 tax law. The losses stem from both Roth conversions and the ability to make nondeductible IRA contributions and then immediately convert them to Roths.
The main difference between a Roth IRA and Traditional IRA is with paying taxes. With a Roth IRA, the money that you contribute into the account is after-tax money, which means that withdrawals in retirement are tax-free. In contrast to a traditional IRA, contributions to a Roth IRA are not tax-deductible. Withdrawals are tax-free under certain conditions (for example, if the withdrawal is only on the principal portion of the account, or if the owner is at least 59ý years old). A Roth IRA has fewer withdrawal restrictions than traditional IRAs. Transactions inside a Roth IRA (including capital gains, dividends, and interest) do not incur a current tax liability. For a Traditional IRA, contributions are tax-deductible or before-tax money, so you pay income tax later when you withdraw the money in retirement. For a Roth IRA, anyone with earned income can contribute to the account at any age, but contribution amounts phase out at higher income levels. A Traditional IRA allows for anyone with earned income to contribute until the age of 70ý.
At the time of withdrawal, a Roth IRA has no required minimum distributions (RMDs), which means that the money in the account can grow for as long as the owner of the account wants. Contributions can be withdrawn anytime tax-free, and earnings can be withdrawn tax-free after five years and age 59ý. For Traditional IRAâÂÂs, one must start taking RMDs at age 70 ý where withdrawals will be taxed as ordinary income. Research suggests that if an investor expects to be in a lower tax bracket in retirement, then they should contribute to a Traditional IRA. A Roth IRA is more beneficial if an investor expects their tax rate to be higher in retirement or if they value tax-free withdrawals and flexibility.
Double taxation may still occur within these tax sheltered investment plans. For example, foreign dividends may be taxed at their point of origin, and the IRS does not recognize this tax as a creditable deduction. There is some controversy over whether this violates existing Joint Tax Treaties, such as the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital.
For Canadians with U.S. Roth IRAs, a 2008 rule provides that Roth IRAs (as defined in section 408A of the U.S. Internal Revenue Code) and similar plans are considered to be pensions. Accordingly, distributions from a Roth IRA (as well as other similar plans) to a resident of Canada will generally be exempt from Canadian tax to the extent that they would have been exempt from U.S. tax if paid to a resident of the U.S. Additionally, a resident of Canada may elect to defer any taxation in Canada with respect to income accrued in a Roth IRA but not distributed by the Roth IRA, until and to the extent that a distribution is made from the Roth IRA or any plan substituted therefor. The effect of these rules is that, in most cases, no portion of the Roth IRA will be subject to taxation in Canada.
However, where an individual makes a contribution to a Roth IRA while they are a resident of Canada (other than rollover contributions from another Roth IRA), the Roth IRA will lose its status as a "pension" for purposes of the Treaty with respect to the accretions from the time such contribution is made. Income accretions from such time will be subject to tax in Canada in the year of accrual. In effect, the Roth IRA will be bifurcated into a "frozen" pension that will continue to enjoy the benefit of the exemption for pensions and a non-pension (essentially a savings account) that will not.
Congress has limited who can contribute to a Roth IRA based upon income. A taxpayer can contribute the maximum amount listed at the top of the page only if their Modified Adjusted Gross Income (MAGI) is below a certain level (the bottom of the range shown below). Otherwise, a phase-out of allowed contributions runs proportionally throughout the MAGI ranges shown below. Once MAGI hits the top of the range, no contribution is allowed at all; however, a minimum of $200 may be contributed as long as MAGI is below the top of the range. Excess Roth IRA contributions may be recharacterized into Traditional IRA contributions as long as the combined contributions do not exceed that tax year's limit. The Roth IRA MAGI phase out ranges for 2021 are:
The lower number represents the point at which the taxpayer is no longer allowed to contribute the maximum yearly contribution. The upper number is the point as of which the taxpayer is no longer allowed to contribute at all. People who are married and living together, but who file separately, are only allowed to contribute a relatively small amount.
However, once a Roth IRA is established, the balance in the plan remains tax-sheltered, even if the taxpayer's income rises above the threshold. (The thresholds are just for annual eligibility to contribute, not for eligibility to maintain a Roth IRA.)
To be eligible, one must meet the earned income minimum requirement. In order to make a contribution, one must have taxable compensation (not taxable income from investments). If one makes only $2,000 in taxable compensation, one's maximum IRA contribution is $2,000.
If a taxpayer's income exceeds the income limits, they may still be able to effectively contribute by using a "backdoor" contribution process (see backdoor contributions below).
Contributions to both a Roth IRA and a traditional IRA are limited to the total amount allowed for either of them. Generally, the contribution cannot exceed your earned income for the year in question. The one exception is for a "spousal IRA" where a contribution can be made for a spouse with little or no earned income provided the other spouse has sufficient earned income and the spouses file a joint tax return.
The Roth annual maximum input increased to $7,000 as of 2024, is a $1,000 increase from prior years and $500 increase from 2023. It is highly recommended that an investor to max-out the annual input amount for maximum return; however, penalties exist for going above the maximum allowable investment amount.
The government allows people to convert Traditional IRA funds (and some other untaxed IRA funds) to Roth IRA funds by paying income tax on any account balance being converted that has not already been taxed (e.g., the Traditional IRA balance minus any non-deductible contributions).
Prior to 2010, two circumstances prohibited conversions: Modified Adjusted Gross Income exceeding $100,000 or the participant's tax filing status is Married Filing Separately. These limitations were removed as part of the Tax Increase Prevention and Reconciliation Act of 2005.
Regardless of income but subject to contribution limits, contributions can be made to a Traditional IRA and then converted to a Roth IRA. This allows for "backdoor" contributions where individuals are able to make Roth IRA contributions even if their income is above the limits.
One major caveat to the entire "backdoor" Roth IRA contribution process, however, is that it only works for people who do not have any pre-tax contributed money in IRA accounts at the time of the "backdoor" conversion to Roth; conversions made when other IRA money exists are subject to pro-rata calculations and may lead to tax liabilities on the part of the converter. In effect, one cannot choose the tax character of the contribution, as it must reflect the existing proportion of tax character in traditional IRAs. For example, for a traditional IRA containing $10,000 post-tax and $30,000 pre-tax funds, it has 75% pre-tax character. Converting $10,000 into a Roth would lead to 75% ($7,500) of the contribution being considered taxable. The pro-rata calculation is made based on all traditional IRA contributions across all the individual's traditional IRA accounts (even if they are in different institutions).
Backdoor Roth IRA contributions were explicitly allowed by the Tax Cuts and Jobs Act of 2017. Prior to that, there was concern that the process would violate the step transaction doctrine that one cannot combine individually legal steps to achieve an outcome that would be illegal if done in a single step.
Returns of regular contributions from Roth IRA(s) are always withdrawn tax and penalty-free. Eligible (tax and penalty-free) distributions of earnings must fulfill two requirements. First, the seasoning period of five years since the opening of the Roth IRA account must have elapsed, and secondly a justification must exist such as retirement or disability. The simplest justification is reaching 59.5 years of age, at which point qualified withdrawals may be made in any amount on any schedule. Becoming disabled or being a "first time" home buyer can provide justification for limited qualified withdrawals. Finally, although one can take distributions from a Roth IRA under the substantially equal periodic payments (SEPP) rule without paying a 10% penalty, any interest earned in the IRA will be subject to taxa substantial penalty which forfeits the primary tax benefits of the Roth IRA.
When a spouse inherits a Roth IRA:
When a non-spouse inherits a Roth IRA:
In addition, the beneficiary may elect to choose from one of two methods of distribution. The first option is to receive the entire distribution by December 31 of the fifth year following the year of the IRA owner's death. The second option is to receive portions of the IRA as distributions over the life of the beneficiary, terminating upon the death of the beneficiary and passing on to a secondary beneficiary. If the beneficiary of the Roth IRA is a trust, the trust must distribute the entire assets of the Roth IRA by December 31 of the fifth year following the year of the IRA owner's death, unless there is a "Look Through" clause, in which case the distributions of the Roth IRA are based on the Single Life Expectancy table over the life of the beneficiary, terminating upon the death of the beneficiary. Subtract one from the "Single Life Expectancy" for each successive year. The age of the beneficiary is determined on 12/31 of the first year after the year that the owner died.