What is a Roth IRA?

Gone are the days when your retirement fund was the money that you stuffed into a sock and kept hidden under the mattress. Well, they’re gone for most people anyway. These days most of us have 401Ks, Roth IRAs, traditional IRAs, and a variety of other retirement accounts. If you are just starting out, the number of possibilities can be overwhelming.

How much should you contribute to your 401k? Should you go with an individual retirement arrangement or IRA? An individual retirement arrangement can be made up of multiple individual retirement accounts by the way. How much should you contribute to it? How do you even open an IRA? Should you do something else entirely?

The best way to get started with retirement planning is to learn the basics. This time around we’ll take a look at the Roth IRA.

Pay Now or Pay Later

With a Roth IRA you will pay taxes on the money that you contribute to the account. This means that when you go to file your taxes, you will not get a deduction for the money that you contributed to your Roth IRA. So, you do not get a tax break up front like you do with a traditional IRA. However, when you withdraw the money from your Roth IRA, which you can start doing when you’re 59 and ½ years old, you will not have to pay taxes on it at that time.

So What?

You might be thinking, “But I’m still paying taxes either way, right?” This is true, no matter how you invest your money you will have to pay taxes on it at some point. The reason the Roth IRA appeals to many people is that they expect to be in a higher tax bracket in the future because they expect to be making more money. Being in a higher tax bracket means you have to pay more in taxes. So, why not pay taxes now when you’re in the lower tax bracket instead of later when you’re in a higher one?

It’s important to note that some people will be in a lower tax bracket in the future. Some people might have less income once they’re retired, and as such, they end up in a lower tax bracket. In this case a traditional IRA might be the better option.

The Devil’s in the Details

These accounts seem simple enough, right? At their most basic, they are quite simple, but there are a lot of regulations that you should keep in mind.

First, your income will determine how much you can contribute to one of these accounts or if you can contribute at all. If you earn over a certain amount (for 2013 it is $127,000 for an individual or $188,000 for a couple filing jointly), you cannot contribute to one of these accounts. If you make between $112,000 and $127,000 (for an individual in 2013) or between $178,000 and $188,000 (for a couple filing jointly in 2013), the amount you can add to your IRA is limited.

Second, your age affects how much you can contribute to your accounts. For 2013 and 2014 you can only contribute $5500 a year if you’re under 50, but you can contribute $6500 a year if you’re over 50.

Third, you can withdraw your contributions early without penalty. Withdrawing your earnings (before you turn 59 and ½) will typically result in a fee, and you will have to pay taxes on the amount. In some cases you can use a certain amount of your earnings to buy your first home, but you still have to pay taxes on the amount you withdraw.

Fourth—that’s not all. There are a lot of details when it comes to a Roth IRA, and it’s always a good idea to consult with a professional prior to opening one.

Getting Started

Credit unions, banks, and brokers all offer Roth IRAs. Different accounts will invest in different things like real estate, stocks, or CDs. You can have multiple accounts (though you only have one Roth individual retirement arrangement), so you don’t necessarily have to choose one over the other. Take the time to look at what each IRA has to offer before you decide which one to open one.

If you don’t have a lot of extra money on hand, you might want to start with a savings account. Many IRAs require a minimum initial deposit. Also, it’s a good idea to have 3 to 6 month’s worth of expenses in a savings account for emergencies before you start opening additional retirement accounts.

Do you have a Roth IRA? Why or why not?

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  • […] IRA you don’t pay taxes now, but you will pay taxes in the future. Some people prefer this to a Roth IRA, where you pay the taxes upfront, for a couple of reasons. For example, you may be in a lower […]

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