Retirement accounts can be confusing with their various acronyms, and many people don’t know the options beyond a company-sponsored 401k plan. A Roth IRA (Individual Retirement Account) lets you put in your post-tax money and withdraw it tax-free during retirement (after age 59 ½). Additionally, you can withdraw your initial contributions minus any gains before age 59 ½, penalty-free. Let’s jump in and learn more about how Roth IRAs work and why you need to start one ASAP.
How Does A Roth IRA Improve Your Financial Future?
Traditional 401k plans let you put in pre-tax money (so you don’t get taxed on it now), then pay taxes when you withdraw it later (presumably when you’re retired and in a lower tax bracket).
A Roth IRA does the opposite. If you’re in a low tax bracket now, it can be more advantageous if you pay tax on your income before depositing it into the Roth IRA, so you’ll be able to withdraw it anytime later without worrying about how much of your gains will be deducted!
This makes it an excellent opportunity for students and workers in entry-level positions who anticipate their salaries to grow significantly over time. According to the IRS, you have to make below $129,000 as a single person to qualify to create a Roth IRA, with allowable deposits phasing out from $129,000-$144,000 (in 2022).
You Can Withdraw Money From A Roth IRA at Any Time
As mentioned earlier, you can withdraw your initial contributions penalty-free at any time, with no age restriction! This makes a Roth IRA an extremely flexible commitment with high liquidity.
In fact, the main difference between a Roth IRA and a normal brokerage account is that you don’t have to pay any capital gains taxes later in life. However, if you withdraw your gains before age 59 ½, you’ll have to pay taxes and a 10% penalty, but just on the gains.
However, there are multiple exceptions for this penalty, such as buying a house for the first time (up to $10,000), needing money for a disability, qualified education expenses, covering the cost of insurance while unemployed, medical/childbirth expenses, and more. Rest assured that in an emergency, you can access most of the funds with no problem and avoid penalties in many situations.
That might sound confusing, so let’s create an example:
I contributed $6,000, and my investments accumulated $500 in earnings (totaling $6,500 in my account). Then, something happens and I need money. I can take out up to $6,000 with zero taxes or penalties. If I need $6,500, however, I’ll need to pay a 10% penalty plus income tax on the $500, leaving me with a bit less than $6,400.
However, if I’m past age 59 ½, or I’m withdrawing money for a qualified expense (as explained above), I can take the entire $6,500 out tax-free!
Ideally, you don’t want to take money out of your Roth IRA before age 59 ½, if you have other cash and investments, because you’d be missing out on that sweet tax-free growth.
How Much Money Can Be Deposited Into a Roth IRA Annually?
In 2022, you can deposit up to $6,000 annually (if you make below $129,000) and you can contribute towards the previous year’s limit until the tax filing deadline in mid-April.
This might not be a significant amount of money for very high earners, and they’d likely be better off contributing toward a Traditional 401k. However, this is still a considerable sum of money if you contribute the maximum every year and you meet the income requirements.
If your money is sitting in a regular investment account, you’re just wasting the chance to accumulate tax-free earnings. No minimum contributions are required for a Roth IRA, so if it makes sense for you to deposit now, just do it! You can always start a traditional retirement account if that becomes a better option and leave your money there to grow.
You can leave some cash in your Roth IRA without investing it, and use it as an emergency fund if you want! Since there’s a strict annual contribution limit, it makes sense to throw money in there when you can, even if you don’t immediately invest it.
Where To Open a Roth IRA Account
At almost every prominent online broker! Highly rated financial companies that offer Roth IRA accounts include Fidelity, SoFi, and Merrill.
After starting an account and transferring money from your bank account, you’ll have to pick some good mutual funds, ETFs, and bonds to invest in and then let your money sit and grow over time. The earlier in your life you start investing in and maxing out your Roth IRA contributions annually, the greater your income potential in retirement. This is thanks to the magic of compound interest! There are many resources online for allocating investments, and some brokerages will even do it for you for a fee.
The Bottom Line
The options are endless, so why not start a Roth IRA if you qualify? You get all the same advantages of a regular investment account, and benefits surpassing all the other options. It’s as risk-free as you can get, with contribution withdrawals anytime.
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