If you are just getting started with retirement and you’re a young adult, then you have probably heard something about the Roth IRA.
I actually use my firm’s Roth 401K, which is a bit different that a traditional Roth IRA, but similar enough that a post about a Roth IRA will give you great insights into the pros and cons of both. Because my firm does not match (meaning they do not match my contribution amount to anything I put into retirement), a 401K does not make sense for me. I would say the Roth IRA for young professionals is fantastic! But that’s because I use the Roth 401k, which is so similar, so I’m biased. 🙂 You’ll have to look at the information yourself and see if the Roth IRA is best for you (or hire someone to do that for you!). And even if you do hire someone, it’s best to know these things yourself, so you’re part of the decision-making process. That said, here are the basics of the Roth IRA.
What Is A Roth IRA?
Roth IRA: A Roth IRA is an individual retirement account that you can open yourself (not an employer) and that you can contribute money to after taxes. After your employer withholds taxes from your pay, you can deposit money into a Roth IRA. Your Roth IRA is an investment account where you can grow your money for retirement. A Roth IRA is an individual retirement account that you open yourself — by definition, there is no employer match (this is your account; not your employers).
Roth 401K: A Roth 401K is a retirement account that you can invest in through your employer. It has the advantages of a Roth IRA, but is an employer plan. If your company does not match and it offers a Roth 401K, you can use the Roth 401K instead of opening a separate Roth IRA. There are additional benefits to a Roth 401K, including higher contribution limits and no income restrictions, as there are in the Roth IRA. But like a Roth IRA, your contributions are done after you pay taxes on your money.
Advantages of a Roth IRA
The biggest advantage (and the biggest reason people like Roths) is that you put money into a Roth account after you pay taxes on the money. So, when you withdraw the money later in life, you do it tax free. Your retirement account grows with after-tax income and when you retire you do not pay any taxes on this money. You pay for the tax now versus later. This is different than a 401K, where you invest the money pre-tax and pay taxes upon withdrawing.
Whether it makes sense for you to pay taxes on your income now versus later depends on your specific situation. However, one way to begin thinking about it is to consider whether you’ll be in a higher or lower tax bracket when you retire. If you think you’ll pay a higher percentage later, then paying tax now may make more sense for you.
Another advantage to a Roth is that you can withdraw your contributions tax free and penalty free. This is appealing to people who may need to use their Roth as a backup emergency fund because you have access to your money without being penalized for withdrawals.
Personally, I cannot even comprehend the thought of withdrawing from my Roth 401K before retirement (I would never ever do that)! That said, this is not about me, it’s about you! Here’s what you need to know about withdrawing from your Roth before you retire…
You can withdraw your direct contributions from your Roth tax free and penalty free at any time. “Direct contributions” means the money you actually deposited. This does not include any interest / growth (i.e. earnings).
To withdraw earnings tax and penalty free, you must wait until you’ve had the account open for 5 years AND you must meet an exemption (such as being disabled, being 59 ½, or being a first time home buyer).
If you do not meet an exemption and you want to withdraw your earnings, you will have to pay a 10% penalty fee AND ordinary income tax on the earnings. Yikes.
Who Can Invest In A Roth
In 2014, anyone who makes less than $114,000 (single) or $181,000 (married filing jointly) can invest in a Roth. If your income exceeds these limits, you cannot use a Roth.
How To Invest In A Roth
If you want to invest in a Roth, you can open an account through a brokerage firm online (Scott Trade, Fidelity, etc.) or at a local brokerage firm or bank.
How Much Can You Invest
There are limits as to how much you can invest in a Roth every year. The maximum contribution limit for 2014 is $5,500 (or $6,500 if you’re 50 years old or older).
You can (and many experts recommend) contributing up to the max – $5,500 per year.
Here’s an example of what investing in a Roth can mean for you. I used this calculator to figure out that if I’m 28 years old and I contribute $5,500 (the max) to a Roth until I’m 50, and then contribute $6,500 until I retire at age 65, I’ll have $1,235,562 (at an estimated 8% rate of return) and will be able to withdraw $101,622 annually for 30 years. Of course the rate of return will vary depending on what you invest in within your Roth, but this shows how compound interest works and the advantages of investing versus simply saving.