What is a Roth IRA?
First things first, what is a Roth IRA? Well, it’s a personal financial plan created to help cover the cost of retirement. These plans can be held in conjunction with other investment accounts, including Social Security, to help fund an individual’s retirement.
Retirement may seem totally irrelevant to younger individuals, but overcoming this notion could drastically alter your future in an incredibly positive manner!
What to consider before opening a Roth IRA
Roth IRAs are great, but there is something even greater: the 401(k). That is, if your employer offers any kind of “match” to your contributions. Matches work in two ways:
- Your employer matches a percentage of your yearly income (such as either a 3% or a 6% match).
- Your employer matches each dollar you contribute with a certain amount (such as a dollar-to-dollar match or a 50 cent-to-dollar match).
The power of the 401(k) is simple: you are get paid for simply contributing. Most modern-day companies have done away with the pension and brought forth the 401(k), making it even more important that you take advantage of the 401(k) plan placed in front of you.
Who is eligible to open a Roth IRA?
The guidelines regarding this can be rather simple. Here’s what to consider:
- Do you have an income?
- Does your income exceed the income limit set by the IRS?
The maximum income for Roth IRAs changes on a yearly basis. For consistent and accurate information on income limits, click here to visit the IRS’s official webpage on the subject.
The tax advantages of a Roth IRA
This is the bread and butter of the Roth IRA. These investment plans have two great tax benefits.
- Roth IRAs are funded with after-tax dollars. This means that the funds you put toward your Roth are taxed BEFORE they enter the account. Because of this, there will be no other point at which you pay taxes on these funds. meaning you can plan on taking out these funds after retirement without any potential tax consequences. This really helps to simplify your finances. Whereas usually it feels like you’re dealing with a million tricks and fees with taxes, here it’s as plain as it gets.
- The Funds in your Roth IRA grow tax-free. This means that all growth within your account (from either capital gains or dividends) is not subject to taxes. You have to understand that this is absolutely AMAZING! This means that you are entitled to every cent produced by the funds in your account.
How time plays a role in your Roth IRA
We are going to talk about what is arguably the most powerful concept in the entire finance industry: compound Interest. Compound interest is the reinvestment of dividends and capital gains, which leads to the eventual exponential growth of an investment account. The results of exponential growth are nothing short of mind-blowing. The chart below shows an investment account with the following attributes:
- held for 40 years.
- $0 initial investment
- $500 invested monthly
- expected 7% annual return
- features an additional 5% and 9% return.
Of course, you can invest in your Roth however you desire, but I think this chart does a great job of visually demonstrating what compound interest can look like for you. Here are some general principles you should follow to have a successful Roth IRA:
The basics of a Roth IRA
- You can withdraw funds placed in the account before 59 1/2 with no consequences, but the removal of earnings from those funds will be taxed and penalized.
- You can invest more if you are 50 or older by the end of that taxable year.
- Roth IRA must have been active for more than 5 years before you can withdraw.
- Check out the official IRS webpage on the subject here.
