How Does a Roth IRA Work?

Sandy Guidicianne, Director, First Republic Bank
January 28, 2022

  • A Roth individual retirement account (IRA) is a type of retirement account that you can contribute to in order to build up savings to use once you retire.
  • You do not pay taxes on investment returns (growth) in a Roth IRA account.
  • The key distinction between a Roth IRA and other types of retirement accounts is you pay taxes annually, rather than when you retire.

Thinking about retirement as early as possible is important. Planning ahead for how you will save for retirement can help ensure you continue to live a comfortable lifestyle, even when your career ends. However, you can consider a few different options when saving for retirement, and it’s important to choose the right one before you begin making contributions.

Tax-free growth, tax-free withdrawals and earlier access to cash, as well as fewer age-restricted rules, make a Roth individual retirement account (IRA) a popular option for many. With a Roth IRA, you won’t need to worry about paying income taxes when you withdraw from your account, which can be a big benefit to your retirement budget.

How does a Roth IRA work, and how does a Roth IRA make money? It’s a fairly straightforward process, which is important to understand if you are considering this type of retirement account. You’ll also want to know how contributions and withdrawals work, as well as the key advantages and disadvantages before you choose an IRA type.

How a Roth IRA grows

How does a Roth IRA make money? That depends on how you invest. Your investments grow and compound. Even in years you aren’t able to contribute to your account, your account may still grow.

Returns vary based on a variety of investments, such as stocks, bonds or mutual funds. The Roth IRA is not an investment in itself, but rather an account that holds your chosen investments. Essentially, your Roth IRA is similar to an account from which you can take cash and use it to purchase investments such as stocks, bonds and funds.

The more you contribute each year, the higher your potential earnings are. For example, if you start contributing at age 30, with an annual contribution of $5,000 at a 7% annual return, you could potentially end up with about $740,000 in savings by the time you retire at 65. Contribution amounts and investment returns will determine the growth of your Roth IRA account.

How Roth IRA contributions work

How does a Roth IRA work? Contributions to Roth IRA accounts are made with post-tax funds. This tax structure is unique to this type of retirement account: Since you pay income tax on the money you invest as you contribute, when you take the money out, you’ll enjoy tax-free withdrawals. 

This tax advantage is a key differentiating factor from other retirement accounts, including a traditional IRA, in which you don’t pay tax up front on annual contributions, so you have to pay taxes when you withdraw from your balance in retirement. 

Regardless of which approach sounds best for your circumstances, you can benefit from starting a retirement savings plan early and making regular contributions in order to grow your wealth for retirement. Even if retirement feels further away for you, thinking ahead can help ensure comfortable retirement years once you get there.

Roth IRA contribution limits

Contributions aren’t limitless. Familiarize yourself with the current maximum annual contribution limits for Roth IRA accounts for those 50 years and older, as well as those for under 50 years old: 

  • Younger than 50 years old: $6,000 annual contribution limit
  • 50 years old or older: $7,000 annual contribution limit

The Internal Revenue Service (IRS) sets income limits on who can contribute to Roth IRAs as well. The cutoff for eligibility depends on your modified adjusted gross income (MAGI). For tax year 2022, if you have a MAGI of more than $214,000 when married filing jointly, or $144,000 for single filers, you cannot make Roth IRA contributions. You can keep your existing Roth IRA open, however.

Withdrawing from a Roth IRA

Roth IRAs are often more flexible than traditional IRAs or 401(k)s regarding withdrawals. The logistics of Roth IRA withdrawal include:

  • Contributions can be withdrawn at any time tax- and penalty-free; however, earnings are subject to penalties and taxes.
  • Unlike other IRA types that usually require minimum distributions to begin at age 72, Roth IRAs do not. Roth IRAs do not require withdrawals until after the death of the owner.
  • Account holders 59.5 years old and older can withdraw both contributions and earnings tax- and penalty-free as long as they’ve had their Roth IRA account for at least five years.

The age rule regarding withdrawals does have a few exceptions, such as buying a first home, college expenses and birth or adoption expenses. It’s best to check with a financial professional before considering a withdrawal from your Roth IRA.

Is a Roth IRA right for you?

Roth IRAs have unique advantages and disadvantages. Understanding them can help you determine whether this type of retirement account is the best option for you. 

Roth IRA Advantages

Roth IRA Disadvantages

  • No taxes paid when withdrawing funds in retirement

  • Tax-free growth on your savings

  • Fewer restrictions on withdrawal, including some advantages for special situations

  • Tax-free withdrawals on contributions at any time

  • Contributions reduced or disallowed depending on how much you earn

  • Pay taxes up front on contributions each year

  • Contributions do not lower your MAGI

Many types of retirement accounts are available as alternatives to a Roth IRA, and it’s important to review these options before deciding which type of plan is right for you, especially since your fit may be different than someone else’s. You do not have to make the decision on your own. A First Republic financial professional can help you determine which retirement account is best for your long-term savings goals. This way, you’ll begin working toward a comfortable retirement with a strategic plan.

The strategies mentioned in this article may have tax and legal consequences; therefore, you should consult your own attorneys and/or tax advisors to understand the tax and legal consequences of any strategies mentioned in this document. This information is governed by our Terms and Conditions of Use