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.
Overview 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):
Year Age 49 and Below Age 50 and Above 1998–2001 $2,000 $2,000 2002–2004 $3,000 $3,500 2005 $4,000 $4,500 2006–2007 $4,000 $5,000 2008–2012 $5,000 $6,000 2013–2018 $5,500 $6,500 2019–2022 $6,000 $7,000 2023 $6,500 $7,500 2024–2025 $7,000 $8,000 2026 $7,500 $8,600
History
Originally introduced as the "IRA Plus", 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to contribute up to $2,000 without receiving an upfront tax deduction; instead, the earnings would grow and be withdrawn tax-free in retirement.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 program’s 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.
Differences from a Traditional IRA The main difference between a Roth IRA and Traditional IRA is how contributions and withdrawals are taxed. With a Roth IRA, all money contributed to the account is after-tax money, and 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 59½ 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, meaning the account holder pays income tax later when they 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 70½.
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 59½. For Traditional IRA’s, one must start taking RMDs at age 70 ½ 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.
Advantages and disadvantages of a Roth IRA
Advantages Direct contributions to a Roth IRA (principal) may be withdrawn tax and penalty-free at any time. Earnings may be withdrawn tax and penalty-free after 5 years if the condition of age 59½ (or other qualifying condition) is also met. Rollover, converted (before age 59½) contributions held in a Roth IRA may be withdrawn tax and penalty-free after 5 years. Distributions from a Roth IRA do not increase Adjusted Gross Income. This differs from a traditional IRA, where all withdrawals are taxed as ordinary income, and a penalty applies for withdrawals before age 59½. Even capital gains on stocks or other securities held in a regular taxable account, so long as they are held for at least a year, are generally treated more advantageously than traditional IRA withdrawals, being taxed not as Ordinary Income, but at the lower Long-Term Capital Gain rate. This potentially higher tax rate for withdrawals of capital gains from a traditional IRA is a quid pro quo for the deduction taken against ordinary income when putting money into the IRA. Up to a lifetime maximum $10,000 in earnings, withdrawals are considered qualified (tax-free) if the money is used to acquire a principal residence for the Roth IRA owner. This principal residence must be acquired by the Roth IRA owner, their spouse, or their lineal ancestors and descendants. The owner or qualified relative who receives such a distribution must not have owned a home in the previous 24 months. Contributions may be made to a Roth IRA even if the owner participates in a qualified retirement plan such as a 401(k). (Contributions may be made to a traditional IRA in this circumstance, but they may not be tax deductible.) If the Roth IRA owner expects that the tax rate applicable to withdrawals from a traditional IRA in retirement will be higher than the tax rate applicable to the funds earned to make the Roth IRA contributions before retirement, then there may be a tax advantage to making contributions to a Roth IRA over a traditional IRA or similar vehicle while working. There is no current tax deduction, but money going into the Roth IRA is taxed at the taxpayer's current marginal tax rate, and will not be taxed at the expected higher future effective tax rate when it comes out of the Roth IRA. There is always risk, however, that retirement savings will be less than anticipated, which would produce a lower tax rate for distributions in retirement. The Roth IRA does not require distributions based on age. All other tax-deferred retirement plans, including the related Roth 401(k),See Final IRS Regulations, passed December 30, 2005 not exempting Roth 401(k) from mandatory distributions at the RMD (Required Minimum Distribution) age. require withdrawals to begin by April 1 of the calendar year after the owner reaches the RMD (Required minimum distribution) age of 72 (prior to the year 2020, the RMD age was 70½). If the account holder does not need the money and wants to leave it to their heirs, a Roth can be an effective way to accumulate tax-free income. Beneficiaries who inherit Roth IRAs are subject to special minimum distribution rules. Roth IRAs have a higher "effective" contribution limit than traditional IRAs, since the nominal contribution limit is the same for both traditional and Roth IRAs, but the post-tax contribution in a Roth IRA is equivalent to a larger pre-tax contribution in a traditional IRA that will be taxed upon withdrawal. For example, a contribution of the 2008 limit of $5,000 to a Roth IRA would have been equivalent to a traditional IRA contribution of $6667 (assuming a 25% tax rate at both contribution and withdrawal). In 2008, one could not contribute $6667 to a traditional IRA due to the contribution limit, so the post-tax Roth contribution may be larger. On estates large enough to be subject to estate taxes, a Roth IRA can reduce estate taxes since tax dollars have already been subtracted. A traditional IRA is valued at the pre-tax level for estate tax purposes. Most employer sponsored retirement plans tend to be pre-tax dollars and are similar, in that respect, to a traditional IRA, so if additional retirement savings are made beyond an employer-sponsored plan, a Roth IRA can diversify tax risk. Unlike distributions from a regular IRA, qualified Roth distributions do not affect the calculation of taxable social security benefits.Internal Revenue Code Section 86(b)(2)(B) A Roth conversion includes the converted pre-tax balance in the account holder's taxable income for the year of conversion, with the tax owed based on the fair market value (FMV) of the converted assets at the time of conversion. When a self-directed IRA holds non-publicly-traded assets — such as private REITs, oil and gas partnerships, or other private placements — the FMV reported by the custodian on Form 5498 may incorporate discounts for lack of marketability or minority interest, which can reduce the conversion tax relative to the assets' undiscounted face value. Such valuations must meet the "willing buyer, willing seller" standard articulated in United States v. Cartwright, 411 U.S. 546 (1973), and underpayments attributable to a substantial valuation misstatement are subject to accuracy-related penalties under Internal Revenue Code § 6662 of 20%, doubling to 40% for gross valuation misstatements. Qualified distributions from a Roth IRA are not included in Modified Adjusted Gross Income (MAGI), so withdrawals in retirement do not increase Medicare Part B and Part D IRMAA surcharges. However, the Roth conversion itself is included in ordinary income and MAGI in the year of conversion, and because IRMAA is determined using a two-year lookback, a conversion can raise the account holder's Medicare premiums two years later if it pushes MAGI above an IRMAA threshold.