What is a Roth IRA?
Roth IRA: How They Work
With a Roth IRA, you can have the benefits of a retirement account without having to make a huge commitment.
The world of finance is complex, filled with both danger and opportunity. Fortunately, there are many resources out there designed to help investors with their retirement savings.
An informed investor, armed with the proper tools and knowledge, will be able to have confidence that their future is secure.
On the other hand, those who are ill informed can have their futures set back years or even decades by poor financial decisions. Don’t be one of those poor investors who lost everything due to being uninformed.
There is no question that we are living in uncertain times. Political unrest, unemployment, and the looming threat of tax hikes are just some of the things we’re dealing with right now. Recessions and market corrections are nothing new, and Americans have dealt with them many times before.
While older investors may have an easier time getting by, young Americans are facing an uncertain future and often don’t give as much thought to their retirement as they should. The increased percentage of college graduates with student debt is increasing while the chances of them finding a high paying job after college are decreasing.
With such a harsh economic environment, it’s not surprising that fewer young people today participate in retirement programs. They view it as hopeless or they don’t believe it’s a worthwhile endeavor at their income level. It’s a shame, because that couldn’t be further from the truth.
What Is a Roth IRA?
A Roth IRA is an individual retirement account in which the investor pays tax on contributions in exchange for having tax free withdrawals.
It is interesting to note that the Roth IRA allows direct contributions to be withdrawn tax free and penalty free at any time. This is great for those who previously had to choose between investing or having savings to deal with emergencies.
With a Roth IRA, investors can safely invest in their retirement without having to think about painful “what if” scenarios. However, it should be understood that penalty free withdrawals only apply to direct contributions, not the earnings from the contributions.
Who Should Use a Roth IRA?
Roth IRAs have specific eligibility requirements as to who can use it, and how they can use it. That said, the people who benefit most from Roth IRAs are young people, and others who have low income. The average American income is well below the maximum income limit on a Roth IRA.
Taxes are paid at the time of contribution at the investors income level, and later taken out tax free. This means that a low income investor can pay taxes at his low tax bracket, and later on take it out tax free even though he would be at a higher tax bracket. It’s practically stealing money from the government, and it’s totally legal.
Due to the restrictions placed on this retirement plan, it isn’t suitable for some people.
In 2016, those filing single must have a MAGI of less than $132,000 in order to be eligible. This limit is placed at $194,000 for married couples who file jointly.
Those who are eligible and are wondering if the Roth IRA is right for them should start with the following question. In retirement, are you going to be paying higher or lower tax rates?
Which tax rate you will pay depends both on your income and the income tax rates set by the government.
Generally, those who are eligible for a Roth IRA will have a higher tax burden later in life. Not only will they be earning more as they get older, but they will also lose some tax deductions such as those given to parents caring for children.
Predicting future tax rates is a little trickier. Ultimately, no one knows what the tax rates are going to be in the future, anything could happen. However, given the political trends in the US it’s probably safe to assume that tax rates will either stay the same or go up slightly, making tax free withdrawals look pretty good.
Roth IRA vs Traditional IRA
In addition to the Roth IRA, there is also the Traditional IRA. In order to help you understand the difference, we’re going to compare and contrast them.
First, both types of IRAs share a yearly contribution limit. In 2016 this limit is set at $5,500, or $6,500 for those aged 50 or older.
For a Roth IRA, a single filer must have an income of lower than $132,000, and for married couples an income lower than $194,000. In a Traditional IRA there are no income limits, but the amount of tax deductions will vary with income level.
Roth IRAs are taxed at the time of contribution, and are tax free at the time of withdrawal. On the other hand, a traditional IRA is tax free at the time of contribution but subject to ordinary income tax at the time of withdrawal.
With a Roth IRA, direct contributions can taken out whenever you want with no tax or penalty fees. In addition, once the account is five years old and the investor is over the age of 59 and ½, all withdrawals are tax free.
With a Traditional IRA, penalty free withdrawals don’t start until the age of 59 and ½.
Is a Roth IRA for you?
At the end of the day, which retirement plan you use is entirely your own decision. When it comes to your savings, you must be your own advocate. Make sure to properly research all the options available to you before making this big decision. We made a quick IRA checklist to help out.
When it comes to retirement, the earlier you start the more savings you will have. Compounding interest is a powerful thing, time is of the essence. Don’t put it off until some other time, secure your future as soon as possible.
Your future self will thank you for putting in the work now so you can reap the rewards later on in your life.
Good article. Definitely good to get people thinking about retirement savings.
Your table was a little deceiving, however, since you forgot to allow the traditional IRA investor to invest his tax savings in a taxable account. The Roth investor would still come out better off, but not quite as far ahead as you said.
And then there is the danger that the US will create a VAT or something in the future that taxes spending, in which case the Roth IRA withdrawals would effectively be taxed as well. I know mathematically that a Roth is normally better, but I don’t mind getting the tax deduction now.
smallivy – thanks for the comment! You are absolutely right, the table is overly simple. I will put a disclaimer on the image to address this. Love your blog btw.