How Does a Roth IRA Work?


A Roth IRA allows investors to contribute money toward retirement with the potential of generating tax-free earnings. Since a Roth IRA is simply a type of account designed to provide favorable tax treatment, investors opening a Roth IRA must then select an investment vehicle they feel balances their risk tolerance with their need for reward.

Contributors to a Roth IRA do not receive an upfront tax deduction. Money is contributed after taxes are applied and is not taxed when it is distributed at retirement as long as certain requirements are met. Early withdrawals can be subject to penalties as well as taxes. Contributions to a Roth IRA are limited based on an individual’s income, and the greatest amount that can be contributed for most individuals as of 2014 is $5,500. The value of a Roth IRA fluctuates based on the performance of the underlying investment. Because this is true, the risks associated with owning a Roth IRA vary greatly. Some common investments owned in a Roth IRA are mutual funds, stocks and bonds. As long as funds are not withdrawn from the account, investments can be bought and sold without causing a taxable event. Upon the death of the account holder, it is possible for a Roth IRA to be passed to an heir without generating estate or income taxes.