WTF is a Roth IRA? A Simple and Straight-Forward Guide

You may have seen or heard the term “Roth IRA” before, but you’re still not completely sure what a Roth IRA is or if you really need one. Well, you’ve come to the right place.

 

In this post, we breakdown the Roth IRA and show you why it’s a great tool for retirement savings.

 

What is a Roth IRA?

A Roth IRA is a type of retirement account. Roth IRAs were named after William Roth, a former Delaware senator who spear-headed the creation of this type of retirement account back in 1997. “IRA” stands for Individual Retirement Account.

 

How Does the Roth IRA actually work?

According to NerdWallet, the Roth IRA allows its owner “to make regular contributions and invest them in a portfolio of stocks, bonds, mutual funds or other investments.”

When you create your Roth IRA, you will choose which investments you’d like to invest in. According to MoneyUnder30, young investors “can and should be aggressive. This means investing mostly in stocks.”

Once you choose your investments, you can begin contributing money to your Roth IRA (for example, you can set up monthly withdrawals from your checking account, or just put a lump sum of money into your Roth IRA at one time). As you put money into your Roth IRA, you are investing. And because you are investing in your Roth IRA, your money will grow faster in your Roth IRA than it would in a typical savings account.

 

Roth IRA Imperfect Finance

Why will a Roth IRA grow my money faster than a regular savings account will?

According to BankRate.com, “the average interest rate for savings accounts is 0.1 percent”. So that means if you have $6,000 sitting in a savings account that has an interest rate of 0.1%, you will earn about $6 on that money in one year for a total of $6,006.

Let me repeat: you’ll keep $6,000 in your savings account for an entire year only to earn six. freaking. dollars.

On the other hand, Roth IRAs have a much higher rate of return. Historically, according to Interest.com, “Roth IRAs return somewhere between 7% and 10% annually”. So let’s say you put that $6,000 into a Roth IRA instead of a savings account, and let’s assume you’ll have a 7% rate of return. After a year, because of that 7% return, you will have earned $420 on your $6,000 for a total of $6,420 in your Roth IRA.

$420 sounds a little better than $6, doesn’t it?  This difference in MASSIVE, especially over time.

 

Here are 5 important things you need to know about Roth IRAs:

 

1. There is a maximum amount that you can contribute to your Roth IRA each year

If you are goal-oriented, then this might be music to your ears: you literally have a set number to strive for in terms of how much you are allowed to put in your Roth IRA each year. For 2022, you can only contribute up to a maximum of $6,000 if you are under the age of 50. If you are over the age of 50, you can contribute up to $7,000.

 

2. You pay taxes on your Roth IRA contributions NOW which means you won’t have to pay them later

If you put money into (contribute to) a Roth IRA, the money must be taxed first. For example, on payday, when your money hits your checking account, your money has already been taxed. Then and only then, are you able to put some of that money toward your Roth IRA.

The good news is that when you want to start withdrawing money from your Roth IRA, you can withdraw your money tax-free (so you don’t have to pay taxes on it!). You can withdraw this money tax-free because you already paid taxes on it before you put it into your Roth IRA to begin with.

 

Coffee and Retirement

3. There are some rules when it comes to withdrawing money from your Roth IRA

A key thing to note is that you can always withdraw any contributions that you made to your Roth IRA and you will not be penalized or taxed if you decide to do that. So if in 2022 you put $6,000 into your Roth IRA and you want to withdraw that money for whatever reason, you can do so without paying any taxes or penalty fees.

That means that you can essentially use your Roth IRA like a (way-more-awesome-than-normal) savings account.

However, be warned: if you do withdraw your contributions, the growth potential that that money once had by sitting in your Roth IRA (retirement account) is gone forever and you can’t get it back. That’s why many recommend to keep your money in your Roth IRA for the long haul. It’s called an Individual Retirement Account for a reason.

Now, you can withdraw your contributions at any time but you CANNOT withdraw your earnings at any time without paying fees and taxes. Remember that $420 that we talked about you earning earlier? That’s an example of earnings on your account.

 

If you are above age 59 ½ and your Roth IRA account is over 5 years old, you’re golden:

You can withdraw the money in your Roth IRA (contributions and earnings) tax-free and penalty-free (yay!).

 

If you are above age 59 ½ and your Roth IRA account is less than 5 years old:

You won’t have to pay a penalty, but you will have to pay taxes on any earnings that you withdraw. There is this thing called the 5 year rule; according to Investopedia, it’s essentially just  “a waiting period before funds can be withdrawn”. So, ideally, you want your Roth IRA account to be over 5 years old before you withdraw from it.

 

If you are below age 59 ½ and your Roth IRA account is over 5 years old:

You can withdraw any and all contributions, but you will have to pay taxes and a penalty if you withdraw any earnings.

 

If you are below age 59 ½ and your Roth IRA account is less than 5 years old:

You can withdraw any and all contributions, but you will have to pay taxes and a penalty if you withdraw any earnings.

 

Note: There are certain circumstances (exceptions) where you may be able to avoid the taxes/penalties if you choose to withdraw your earnings when they would normally be taxed/penalized. Here is a great graphic from IRS.gov that explains this all very clearly:

Roth IRA withdraw limits

4. Not everyone can contribute to a Roth IRA

The amount of money you can contribute to a Roth IRA begins to phase out at a specific income level, and then eventually completely phases out after a certain income level. Here is a great graphic from IRS.gov that explains this:

Roth IRA Contribution Limits

5. You have until the tax deadline the following year to finish your Roth IRA contributions for that tax year

Let’s say you haven’t put any money into a Roth IRA in 2022 yet. Well, you actually have until next April 15, 2023 (or Tax Day 2023) to max out your Roth IRA (contribute $6,000) for 2022. Cool, right? So if you haven’t started contributing to your Roth IRA for 2022 yet, don’t fret – there’s still time!

 

Lastly… you have got to check out this Roth IRA calculator!

If you made it this far in the blog post, you’re in for a treat. Nerdwallet has an incredible free Roth IRA calculator tool on their website that takes less than 30 seconds to fill out.

Essentially, the tool asks for your age, your income before taxes, your current Roth IRA balance (you can put $0!) and your marital status for tax filing purposes and it will estimate your Roth IRA balance at retirement age assuming you max it out (contribute $6,000) every year until you retire.

Here is an example of a young woman who is 25 years old, makes $45k a year, has NO money in her Roth IRA today and is single (not married). Look how much money she will have in her retirement account if she maxes out her Roth IRA each year (puts $6,000 in a year) until she is 67:

RothIRACalculatorNerdWallet

Yep, you read that right. Over $1 million dollars in her Roth IRA. Try it for yourself! Click here.

Note: You must do your own research on Roth IRAs before making any financial decisions. This is for educational purposes only.

 

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A few years after graduating college, Taylor made it her mission to become debt free. After paying off all $60k of debt, she began to blog about what she's really passionate about: personal development. Nowadays, Taylor blogs about the topics of Mindset, Money, Health, and Career for women. Read more about Taylor here.

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