One of the best ways to save for retirement is in a Roth IRA.
The Roth IRA is an excellent tool to save for retirement. But not everyone can contribute to a Roth IRA — you have to have income below certain thresholds (more on that below). You also have to open this account at a brokerage firm yourself (unlike an employer sponsored retirement plan, like a 401k).
But it’s good — the Roth IRA is really freaking good.
- Related: How to Start Saving for Retirement
What Is A Roth IRA?
Roth IRA: A Roth IRA is an individual retirement account that you open yourself (not through your employer). With a Roth IRA, you contribute money after you pay taxes on that money (i.e. after you get the money from your paycheck). After your employer withholds taxes from your pay, you can deposit money into a Roth IRA. The annual contribution limit for a Roth IRA in 2018 is $5,500 (for people under 50).
What happens next is the kicker — your money grows tax free. Meaning, your money will grow and grow based on how the market performs, getting lots of compound interest. When you withdraw this money, you don’t ever pay taxes on it. This is awesome and unlike all other retirement accounts (except for a Roth 401K).
Roth 401K: A Roth 401K is a retirement account that you can invest in through your employer but works very similarly to a Roth IRA. It has the advantages of a Roth IRA (contributing after-tax dollars and growing tax free), but is an employer plan and has higher annual contribution limits ($18.5k in 2018 for people under 50). 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.
Advantages of a Roth IRA
The biggest advantage 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. You can’t predict what tax bracket you’ll be in when you retire, so there’s an inherent risk and unknown with 401Ks and IRAs with respect to taxes.
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. But it’s impossible to know for sure (i.e. tax law changes all the time).
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.
You can withdraw your contributions from your Roth IRA tax free and penalty free at any time. “Contributions” means the money you actually deposited. This does not include any growth (i.e. earnings).
Personally, I cannot comprehend withdrawing from my Roth 401K before retirement (I would never ever do that)! That said, this is not about me, it’s about you! So, just know that you can do it.
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 2018, anyone who makes less than $120,000 (single) or $189,000 (married filing jointly) can invest in a Roth IRA. If your income exceeds these limits, you cannot use a Roth IRA, and would need to consider other options, like a Traditional IRA (read more on this from the IRS).
How To Invest In A Roth
If you want to invest in a Roth IRA, you can open an account through a brokerage firm online (Schwab, 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 2018 is $5,500 (or $6,500 if you’re 50 years old or older).
If you can afford it, many experts recommend contributing up to the max – $5,500 per year if you’re under 50 years old.
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.
A Final Note!
It’s never too soon to start saving for retirement. Read more on saving for your retirement here.