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A Roth individual retirement account (IRA) is a retirement savings account that a person can contribute to each year. Under certain circumstances, funds can be withdrawn tax-free.
The money saved in a Roth IRA can be invested in financial instruments, such as equities, bonds, or savings accounts. Contributions to a Roth IRA are made with after-tax money, meaning that the contributions are made after income taxes have been withdrawn from the account holder’s paycheck.
Roth IRAs offer a long-term tax benefit since withdrawals of contributions and investment earnings are not taxed in retirement. However, Roth IRAs may not be the right retirement account for everyone. Although there are benefits to Roth IRAs, there are also distinct disadvantages that should be considered.
Key Takeaways
- Roth individual retirement accounts (IRAs) offer several key benefits, including tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions (RMDs). However, they have drawbacks as well.
- One key disadvantage: Roth IRA contributions are made with after-tax money, meaning there’s no tax deduction in the contribution year.
- Another drawback is that withdrawals of account earnings must not be made until at least five years have passed since the first contribution.
- This five-year rule may make Roths less beneficial to open if you’re already in late middle age.
- Roth IRAs’ tax-free distributions may not be advantageous if you’re in a lower income tax bracket when you are retired.
Roth vs. Traditional IRA
Roth and traditional IRAs are excellent ways to stash money away for retirement. However, there are annual contribution limits.
For 2023, individuals can contribute a maximum of $6,500 each year or $7,500 if they’re age 50 or older.
To contribute to either, you must have earned income, which is money earned from working or owning a business. Also, you cannot deposit more than you’ve earned in a given year.
Despite these similarities, the accounts are actually quite different. Below are the disadvantages of Roth IRAs.
Roth IRA Income Limits
One disadvantage of the Roth IRA is that you can’t contribute to one if you make too much money. The limits are based on your modified adjusted gross income (MAGI) and tax filing status. To find your MAGI, start with your adjusted gross income (AGI)—you can find this on your tax return—and add back certain deductions.
In general:
- You can contribute the full amount if your MAGI is below a certain amount.
- You can make a partial contribution if your MAGI is in the phaseout range.
- If your MAGI is too high, then you can’t contribute at all.
Below is a rundown of the Roth IRA income and contribution limits for 2022 and 2023.
| 2022 Roth IRA Income and Contribution Limits | ||
|---|---|---|
| Filing Status | MAGI | Contribution Limit |
| Married Filing Jointly or Qualifying Widow(er) | ||
| Less than $204,000 | $6,000 ($7,000 if age 50+) | |
| $204,000 to $214,000 | Phase out range | |
| $214,000 or more | Ineligible for direct Roth IRA | |
| Married Filing Separately | ||
| Less than $10,000 | Phase out range | |
| $10,000 or more | Ineligible for direct Roth IRA | |
| Single or Head of Household | ||
| Less than $129,000 | $6,000 ($7,000 if age 50+) | |
| $129,000 to $144,000 | Phase out range | |
| $144,000 | Ineligible for direct Roth IRA | |
| 2023 Roth IRA Income and Contribution Limits | ||
|---|---|---|
| Filing Status | MAGI | Contribution Limit |
| Married Filing Jointly or Qualifying Widow(er) | ||
| Less than $218,000 | $6,500 ($7,500 if age 50+) | |
| $218,000 to $228,000 | Phase out range | |
| $228,000 or more | Ineligible for direct Roth IRA | |
| Married Filing Separately | ||
| Less than $10,000 | Phase out range | |
| $10,000 or more | Ineligible for direct Roth IRA | |
| Single or Head of Household | ||
| Less than $138,000 | $6,500 ($7,500 if age 50+) | |
| $138,000 to $153,000 | Phase out range | |
| $153,000 or more | Ineligible for direct Roth IRA | |
Married taxpayers filing separately can use the single/head of household limits if they have not lived with their spouse at any time during the tax year.
Backdoor Roth IRA
There’s a tricky but perfectly legal way for high-income earners to contribute to a Roth IRA even if their income exceeds the limits. This is called a backdoor Roth IRA, which entails contributing to a traditional IRA and immediately rolling over the money into a Roth account.
This transaction must be done strictly by Internal Revenue Service (IRS) rules.
Roth IRA Tax Deduction
The biggest difference between traditional and Roth IRAs appears when the taxes are due.
A traditional IRA deducts your contributions in the year when you earn them. This provides an immediate tax break that leaves you with more money in your pocket. The downside is that income taxes are due on both your contribution and the money it earns when you make withdrawals during retirement.
Roth IRAs work the opposite way. You don’t get an up-front tax break, but withdrawals in retirement are generally tax-free.
That sounds good, but it can be a disadvantage for some investors.
You make Roth IRA contributions with after-tax dollars, so you don’t get the up-front tax break traditional IRAs offer.
Here’s why: No up-front tax break means that you’ll get less money in your paycheck to spend, save, and invest. And tax-free withdrawals in retirement are something to look forward to—unless you’ll be in a lower tax bracket in the future than you are now.
Depending on your situation, you could benefit more from a traditional IRA’s up-front tax break and then pay taxes at your lower rate in retirement. It’s worth crunching the numbers before you make any decisions since there’s potentially a lot of money at stake.
Roth IRA Withdrawal Rules
With a Roth IRA, you can withdraw your contributions at any time, for any reason, without tax or penalty. In addition, qualified withdrawals (which include contributions and account earnings) in retirement are also tax and penalty-free. To be qualified, the withdrawals must occur when you’re at least 59½ years old and it’s been at least five years since you first contributed to a Roth IRA—also known as the five-year rule.
If you don’t meet the five-year rule, then any earnings that you withdraw could be subject to taxes or a 10% penalty—or both, depending on your age:
- Ages 59 and younger: Withdrawals of earnings are subject to taxes and a 10% penalty. You may be able to avoid the penalty (but not the taxes) if you use the money for either a first-time home purchase or certain other exemptions.
- Ages 59½ and older: Withdrawals of earnings are subject to taxes but not penalties.
The five-year rule can be a disadvantage if you start a Roth later in life. For example, if you first contributed to a Roth at age 58, you must wait until you’re 63 to make tax-free withdrawals.
Can I Withdraw Contributions Without Triggering the Five-Year Rule?
Yes. Your contributions can be withdrawn at any time without penalty or taxes. Only earnings are subject to the five-year rule.
What Is My Modified Adjusted Gross Income (MAGI)?
Your modified adjusted gross income (MAGI) is your adjusted gross income (AGI) with a few deductions added back. Deductions reapplied include half of the self-employment tax, deductions for student loan interest, rental losses, and more.
Do Roth and Traditional Individual Retirement Accounts (IRAs) Have the Same Income Limits?
No. There are no income limits to contribute to a traditional individual retirement account (IRA). Roth IRAs base your ability to contribute the maximum of $6,500 for 2023 on your MAGI. People over age 50 can contribute an additional $1,000 catch-up contribution. However, the deduction for your contributions to a traditional IRA may be limited if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels.
The Bottom Line
Roth IRAs offer many benefits; tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions (RMDs) starting at age 72. However, there are potential drawbacks.
Typically, individuals benefit from saving for retirement in an IRA. However, whether a traditional or Roth IRA is better depends on several factors, including your income, age, and when you expect to be in a lower tax bracket—now or during retirement. Please consult a tax expert, financial planner, or financial advisor to help you make a more informed decision so that your retirement plan is customized for your specific financial situation.
