What is a Roth IRA? : How to Invest Your Money Like a Boss

What is a Roth IRA and Should I Open One?

What is a Roth IRA? What is a traditional IRA? What is a 401k? HSA? 403b? If you’re a beginning investor (and yes, you should start to refer to yourself as an investor!), knowing where to start can feel super overwhelming!

Retirement planning is extremely important, and the earlier you get started the better. So why doesn’t anyone teach you this stuff?!

I wish I knew the answer to that, but unfortunately I don’t. Luckily, even if you are brand new to personal finance and you feel like you have no idea how to do all this adulating stuff, there is still hope.

There are tons of great personal finance books, and the internet is full of places to learn more about investing for retirement. The best way to get your feet under you financially is to read, read, read.

It is important to note that I am NOT a certified financial expert, and none of the information in this post should be construed as specific investing advice.

You need to always do your own due diligence before making any investing decisions.

Retirement Planning Basics

If you have a good understanding of the basics of retirement planning, feel free to jump ahead, but if you’re unsure about some of the ins and outs, this is a good place to start.

First of all, it is important to understand why you need to start investing early for retirement. Can’t you just work ‘til you are dead?

Well, I guess in theory that is possible, but let’s be real. Who really wants to work forever? I know some people love their jobs, but even still, there will come a time when you likely won’t be able to work anymore. At least not at the level you are now.

The reason you need to start saving early is because of a beautiful thing called compounding interest. When you earn compounding interest it means that as your account grows because of interest, you then receive interest on your interest.

So you are getting interest on money that you never even directly put into your account.

It’s pretty amazing. Since your interest compounds over time, the sooner you get started the more money you will end up with at retirement.

Take a look at this example.

What this shows you is that if you wait just 10 years to start investing, you will have HALF the amount saved by age 65 as you would have if you started earlier.

It is easy to say to yourself, I’ll start saving “when I get a raise”, “when I pay off student loans” or “after I have kids”. You get the idea.

But take a look at the bottom row where it says interest earned. If you choose to postpone your retirement savings 10 years, you could end up earning $615,219 less in FREE money (interest).

So, now that you have hopefully seen the light and are ready to start investing for retirement, there are several different avenues you can choose.

I mentioned some of them before, but the ones you hear about most often are 401ks, Roth IRAs, and IRAs.

This post is going to dig into Roth IRAs, because going into all of them at once would just get messy.

What Is a Roth IRA?

If you’re confused about all the different retirement investment accounts and are wondering “what is a Roth IRA”, you are not alone. Keep reading to get a better grip on this retirement savings plan.

A Roth IRA is an individual, after tax retirement savings plan.

So what does that mean exactly? Well, since you have already paid tax on the money you are contributing to a Roth IRA, that means that your money can grow tax-free all the way into retirement.

So, when you eventually start withdrawing that money, you won’t owe any taxes on it! Woohoo!

This is much different from a traditional IRA or a 401k as both of these accounts invest PRE-tax dollars. Since the money in a traditional IRA and a 401k wasn’t taxed when it was put into the account, you have to pay taxes on it when you withdraw it.

You are allowed to contribute (as of 2019) up to $6,000 annually to a Roth IRA. You also have until April 15^th (tax day) of the following year to max that out (max out=contribute the maximum amount allowed, in this case $6,000).

So if, for example, you can’t quite max out in 2019, you could put a bit extra into the account in January and February of 2020. If you choose, this money deposited in 2020 would actually go towards your 2019 contribution amount.

This is something you can decide when you are contributing money to your account.

What is Unique About a Roth IRA?

In addition to having your money grow tax-free, a Roth IRA has several other unique factors that are worth considering.

Penalty-Free Withdrawals

First, you are allowed to withdraw money you contributed (but not interest) after 5 years without a penalty. You can’t withdraw interest without a penalty though (and it is hefty at 10%).

Using Money from a Roth IRA to Purchase a Home

Second, you are allowed to use up to $10,000 from your Roth IRA to help fund the purchase of your first home.

This is good to know especially if you receive a large lump sum of money, but don’t plan to buy a home in the near future. Investing it in a Roth IRA will net you significantly more interest than a regular savings account.

If you are planning to buy a home in less than 3-5 years however, a traditional or high yield savings account is a safer place for your money.

Money in the bank is insured and you can be certain you won’t lose it whereas money deposited into a Roth IRA account could be lost if your investments don’t work out.

In most situations, the short term benefits of a bit more interest aren’t worth it for house savings, but if you plan to leave the money be for longer, then it might make sense for you.

Just know, that you can use money from your Roth IRA to help fund a house purchase if you choose.

Although in my humble opinion, I would avoid borrowing from my retirement if at all possible (see the power of compound interest above).

No Minimum Distributions Required

While other retirement investment accounts REQUIRE you to start withdrawing money at a certain age, no such requirement exists for Roth IRAs.

This can be a really good thing for several reasons.

If you are withdrawing less from this account, you will continue to accrue interest on all the money left in there.

Additionally, if you hope to leave a large estate for your family upon your death, a Roth IRA will allow your contributions to continue growing rather than shrinking due to required distributions.

Who Would Benefit from a Roth IRA?

A Roth IRA tends to be most financially beneficial for individuals who are in a lower tax bracket now than they expect to be in during retirement.

So, say you are just starting out your career and aren’t making a ton of money. The amount you are taxed now may be significantly less than what you will be taxed in retirement.

If you contribute money to a pre-tax account, like a 401k, and end up in a higher tax bracket when you retire, you will end up paying more in taxes when you withdraw that money.

You will also have to pay taxes on all the interest you earned over the course of your working life if you invest in a 401k or traditional IRA.

If you expect your salary to increase significantly throughout your career and you plan to maintain a higher income type of lifestyle in retirement, a Roth IRA could be a great investment avenue for you early in your career.

A Roth IRA can also be a good way to diversify your investments so that you can withdraw some money tax-free in retirement while paying taxes on other money withdrawn to provide the lifestyle you want.

It is important to note that while a 401k or traditional IRA can help decrease your taxable income, the same is not true for a Roth IRA. You cannot deduct contributions to a Roth for tax purposes.

What is a Roth IRAs Eligibility Requirements?

Roth IRAs do have some eligibility requirements. Depending on your income, you may or may not be able to invest in a Roth IRA.

The information in the table below is based on information from the IRS and is up to date for the year 2019.

So, as you can see, once you reach a certain income level, you are no longer eligible to invest your money in a Roth IRA. In this case, you’ll need to consider alternative investment avenues.

Getting Started

There are multiple different investment companies with which you can open a Roth IRA account. I personally use Vanguard as they have some of the lowest fees around.

Lower investment fees mean more money for you, so this is something important to consider when choosing where to invest.

One of the best things you can remember with a Roth IRA or any other type of investment is this. Don’t invest money you can’t afford to lose. The market can always change, and you need to remember that when making decisions.

In general, the average rate of return over 30 years is around 6-12% interest rate, so if you choose smart investments, you should be sitting pretty good at retirement.

And if the market tanks, remember not to panic! Stay the course, because you are in it for the long haul.

Want more money to add to your account? Check out these tips to save money.

If you are still wondering “What is a Roth IRA?” or if you have any other questions, feel free to drop a comment below, and I will be happy to respond!