Roth IRA: How it works & why consider it

An individual retirement account (IRA) allows you to save for retirement in a tax-advantaged way. But a Roth version of an IRA has some special features that may make a notable difference in your retirement savings.

Here's what you should know.

A Roth IRA is funded by money that you've already paid taxes on—also known as after-tax dollars—so withdrawals are tax-free. While there is no tax deduction for Roth IRAs, your investments grow deferred in the account, and you don't pay income taxes on qualified withdrawals.¹

You can invest the money in a Roth account in a variety of assets, including stocks, bonds, mutual funds and exchange-traded funds (ETFs).

Anyone who has earned income (according to the IRS definition) can contribute to an IRA. Earned income is money from a job or self-employment. Income that doesn't qualify as earned includes rental income, capital gains, IRA distributions, Social Security retirement benefits, interest and dividends.

Unlike traditional IRAs, Roth IRAs have income limitations:

Roth IRAs work similarly to other retirement plans. You make contributions and, when eligible, you take distributions to fund retirement or other qualified needs.

• 2023 contribution limits: $6,500 under age 50; $7,500 age 50 or older

There are several ways to fund a Roth IRA including regular contributions, Roth conversions and rollover contributions.

You can open an IRA account by working with a financial services firm. You can contribute directly. The deadline to contribute to a Roth IRA is typically April 15 of the following tax year. (If April 15 falls on a weekend or holiday, the deadline typically shifts to the following business day.)

One way to fund a Roth IRA is to convert a traditional IRA into a Roth.³ You can perform a Roth conversion regardless of how much you earn. When you convert a traditional IRA into a Roth, you're taxed as if you received a distribution.

You can minimize this tax hit in a few ways. For example, you might perform a Roth conversion in a year in which you have a dip in income and are therefore in a lower tax bracket. You also can spread your conversion out over a few years instead of getting hit with the tax bill all at once.

Deciding whether to convert your traditional IRA into a Roth—and planning for the tax bill—is complex. For this reason, it's a good idea to discuss the possibility with your financial advisor and tax professional.

> Read more about the pros and cons of Roth conversions.

You also can roll over funds from an employer-sponsored retirement plan, such as a 401(k), into a Roth IRA.⁴

If the plan allows for Roth 401(k) contributions, you can roll these amounts directly into a Roth IRA. Otherwise, you can convert non-Roth funds into a Roth IRA and pay taxes on the conversion just as you would when converting a traditional IRA into a Roth.

Now that you understand the basics of a Roth IRA, here's a quick look at the differences between traditional and Roth IRAs:

Learn more about the differences between traditional and Roth IRAs.

Qualified withdrawals from a Roth IRA are the payments you can take after reaching age 59½ and meeting the five-year rule. These withdrawals aren't taxable, and you won't owe a penalty for taking the money out.

However, if you don't meet both requirements,¹ you have a nonqualified distribution. In that case, taxes and penalties depend on whether you withdraw your original contributions or your contributions and earnings.

You can withdraw your original contributions to a Roth IRA tax-free and penalty-free at any time. But you'll owe income taxes if you withdraw any earnings from the account within five years of making your first contribution and before turning 59½. You also will owe a 10% early withdrawal penalty if you don’t meet one of the IRS penalty exceptions.

Once you've had the account for five years and turn 59½, you can withdraw both earnings and contributions from your Roth IRA for any reason without paying income taxes or penalties.

Thankfully, there are a few exceptions to the Roth early withdrawal penalty rules. This makes it possible to withdraw money during times of need, when your options may be limited. You can find more information on the exceptions here.

The Secure Act 2.0 also recently added additional and changed some existing exceptions to the 10% early withdrawal penalty including expenses related to a terminal illness, "hardship" withdrawals due to domestic abuse, premiums for long-term care contracts and family emergencies. Depending on the exception, the changes will be rolled out between 2023 and 2025.

No, RMD rules don't apply to Roth IRAs. So, if you don't need the money for living expenses in retirement, you can leave it in your account indefinitely. However, your beneficiary will be subject to withdrawal requirements.

When considering a Roth IRA, think about your current earnings. It's impossible to predict the future, but if you expect tax rates to increase or anticipate being in a higher tax bracket when you retire, contributing to a Roth IRA might be right for you. This can allow you to pay taxes on the money used to fund your Roth now at the current rates, and then enjoy tax-free income in retirement.

On the other hand, if you expect tax rates to decrease or believe you may be in a lower tax bracket when you retire, a traditional IRA might be the option to consider. Traditional IRA contributions allow you to benefit from tax-deductible contributions now and pay taxes at a lower rate in retirement.

While deciding what's right for you can seem complex, it's important to remember that a Roth IRA is ultimately meant to provide support during your golden years. You work hard so that you can enjoy carefree years after leaving your profession. Figuring out the best ways to manage this retirement account can greatly benefit you as well as your heirs.

If you're interested in learning more about the benefits of a Roth IRA or converting an existing retirement account into a Roth account, connect with a local Thrivent financial advisor. They can help you learn more about the nuances of saving for retirement and how a Roth IRA may complement your plan.