What is a Roth IRA?

Saving for retirement is one of the most important gifts you can give yourself, especially when you’re young. In the US, the average social security check was $1503 per month in January 2020 (that’s average, which means a lot of people are making a lot less.) While you can live on $1503 a month, in most of the country that won’t get you very far–especially when you have to account for healthcare needs in old age.

Since the government knows they will not be paying for your retirement, there are a few tax-advantaged programs available to encourage you to save your own money. Unfortunately, few take advantage of this “gift” from Uncle Sam, even if they can afford to put a few hundred dollars extra away per month.

What is a Roth IRA?

• A Roth IRA allows you to pay tax this year on income and then put that money into an account that can grow tax free forever.
• It is a type of account — you can buy stocks, index funds, bonds or other investments inside of your Roth IRA. Your goal should be to get it to grow over time.
• If you take the money and earnings out before you are 59 1/2 you will be subject to penalty on the earnings only. Since you already paid tax on the money you put in, you never have to pay tax on it again. You need to wait 5 years to take it out, though, or you will have a penalty on you investments.

This sounds great. What’s the catch?

If you’re a moderately high earner, you can’t contribute to a Roth IRA.

**You can do a Backdoor Roth IRA (I’ll explain that in another post) but you can’t contribute the full $6000 a year to a Roth if you make over $196k joint or $126k single. If you make less than this, you can contribute that full amount. If you make over this income, you can contribute less until you hit the phase out income amount, which isn’t much higher.

Why wouldn’t I invest in a traditional pre-tax IRA instead?

Some people do prefer to invest in a traditional IRA. This IRA type is pre-tax — you don’t pay tax on the money now, but you do pay tax on it when you tax it out after it has grown.

When you run the numbers, a Roth and regular IRA turn out exactly the same if your tax rate is the same now and in retirement. Don’t believe me?

• Pre-tax: $1000 now + 5% a year for 30 years = 4,321.94 x 30% tax = $3025.36
• Post-tax (Roth): $1000 now, 30% tax = $700 + 5% a year for 30 years = $3025.36

Witchcraft? Nah, it’s just math.

So why choose the Roth over the regular IRA?

If you’re eligible for both, you may think the pre-tax is the better choice. It does reduce your tax liability right now. This means you make more this year (as we can see above, if you are paying 30% taxes, you would contribute $1000 this year vs $700 in a Roth.) However, you are betting that your tax rate now will be higher than or equal to your tax rate in retirement.

Generally speaking, people think tax rates will go up over time. Rates are at historic lows right now. So investing in a Roth is betting that you will be in a higher tax bracket in retirement than you are today.

Roths have other advantages. You can take out your contributions before 59 1/2 tax free (though you should try to not touch them until retirement.) You also can pass on your Roth earnings tax free to your heirs when you pass on, whereas your IRA would be taxed at their tax rate.

Overall, if you are in a low income tax bracket now, it is in your best interest to max out your Roth IRA each year if you can manage the $500 a month contributions. If you can’t do the full $500, consider whatever you can afford to get started.

• If you’re covered by a retirement plan at work (ie 401k), you need to make $65,000 or less as a single person or $104k or less married together to be eligible for the tax deduction.
• If you are not covered by a retirement plan at work (and your spouse also isn’t if you are married), you are allowed to tax the full deduction up to $6000.

In terms of investing, over time your money will grow. Imagine you are 20 today. You will retire at 65. That gives 45 years for your money to grow. At a moderate growth rate of 5% a year, you will have $1,060,021 in retirement. If you can average 7% a year (which is reasonable in a diversified index fund), you will have $1,960,925! All from contributing $6000 a year starting at age 20.

Note — to invest in an IRA or Roth IRA you need earned over-the-table income. You need to report the income to the government. You can be any age as long as you have earned income and contribute (some parents have their kids pick up modeling or TV acting and contribute these earnings to their kid’s Roth.)

You can open up a no-fee Roth IRA at Vanguard or Fidelity. You will want to determine how to invest your account when you open up the Roth IRA. I will cover this in another post soon.

Questions? Ask away!