What is a Roth IRA?

What You Need to Know About a Roth IRA

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Confession: when I graduated from college, I did not know the first thing about a Roth IRA, much less how it differed from a traditional IRA or a 401(k). It took countless phone calls to my parents and a few "Roth vs. Traditional IRA" Google searches for me to finally get it down. In fact, a Roth IRA may be one of the most baffling personal finance concepts for millennials. And this is a serious problem because a Roth IRA is actually a helpful, tax-efficient way to save for retirement. Especially for young people!

What is a Roth IRA?

A Roth IRA is a special kind of retirement account that differs from a traditional IRA and a 401(k) in the way your money is taxed. Let's break it down. With a traditional IRA or 401(k), your contributions are tax deductible. That means you don't have to pay taxes on them until you withdraw your savings in retirement. With a Roth IRA, the timing reverses. The dollars you contribute today are taxed upfront. But when you withdraw your savings in retirement, you won't owe any income tax.

The best part about a Roth IRA is that your money grows completely tax-free. Within your Roth, you can invest in a variety of stocks, bonds, mutual funds, and other asset classes. The gains you receive from these investments can be pretty substantial thanks to compound interest. And you won't owe a cent of it to the IRS! With a traditional IRA, all of these gains are subject to ordinary income tax when you withdraw.

To summarize, a traditional IRA means you pay taxes later. A Roth IRA means you pay taxes today, but your contributions and earnings grow tax-free. Logically, it makes sense to contribute to a Roth if you think your tax bracket today is lower than it will be in retirement.

Roth IRA Eligibility

Naturally, there are some Roth IRA limits and rules. First, you are ineligible to contribute if your adjusted gross income is over $133,000. If your income falls in the $118,000 to $133,000 range, your 2017 Roth contribution limit reduces according to an IRS schedule. If your income is below $118,000, you can contribute $5,500 per year.

If you are ineligible to contribute to a Roth IRA, there is a "Backdoor Roth IRA" option that many don't know about. This involves making a nondeductible contribution to a traditional IRA and then converting it to a Roth. This can get complicated, so it makes sense to consult a tax professional before you get started.

5 Benefits of a Roth IRA

If you are eligible for a Roth IRA, I would encourage you to open one today for five reasons:

  • Tax benefits. Your contributions will grow and compound tax-free. If a 25-year-old contributes $5,500 to a Roth IRA each year until age 65 and makes an annual return of 8%, she will have saved $1.7 million! And she won't owe a cent of it to the IRS.
  • Diversified income stream. A Roth IRA will diversify your retirement income from a tax perspective. If you already have a 401(k) or a traditional IRA, it could benefit you to add another income stream with a different tax characteristic.
  • Flexibility. A Roth IRA provides flexibility in a pinch. You can withdraw your contributions (not earnings) without penalties before age 59 1/2.
  • No minimum distributions. A traditional IRA requires you to take minimum distributions at age 70 1/2 and pay income tax on each withdrawal. A Roth IRA allows you to withdraw what you want, when you want, without taxes.
  • Efficient estate planning. If you don't need your Roth funds during your lifetime, you can pass it down to your beneficiaries, and they won't owe income tax either. While estate planning may be off the radar for my younger readers, a Roth IRA is a very efficient way to transfer wealth.

Pro tip: You can contribute to both a Roth IRA and a 401(k) at the same time. But if your employer offers matching benefits on your 401(k), prioritize this first. Make sure you contribute at least as much as your employer will match, or you'll leave money on the table. If you still have room to save, then you should contribute to your Roth IRA.

How to Open a Roth IRA

Your employer has to open your 401(k), but it's easy to open a Roth on your own. I keep mine with Wealthfront because I prefer a hands-off approach. Wealthfront invests the dollars in my Roth according to my personal risk profile. However, you can open a Roth IRA with a variety of brokers and IRA providers. For more options, Nerdwallet has a great post on the best Roth IRA accounts.

The Bottom Line

A Roth IRA is an effective way to save for retirement, so it's unfortunate that many people don't understand it. I encourage all eligible individuals to open an account! A Roth IRA offers more flexibility than any other retirement plan and allows you to withdraw your funds tax-free as you sip your margaritas on the beach.

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