The Roth IRA In A Nutshell

The Roth IRA Explained - Stash Wealth
Photo by Priscilla Du Preez on Unsplash

It’s no surprise that we are fans of the Roth IRA. We’re not the only ones. A lot of blogs mention it as a great vehicle for retirement savings. While we agree it’s a pretty sweet deal and Millennials especially should be using it, do you understand why?

 

Before we dig in.

 

Let’s first discuss what a Roth IRA is by discussing what it is not.

 

What a Roth IRA is not?

IRA stands for Individual Retirement Account – in other words, an account that you, as an individual, set up for yourself, rather than one that is set up for you by your employer, aka a 401(k). From time to time we hear people say, I don’t think a Traditional IRA (or Roth IRA) is a good investment. Well guess what! An IRA is not an investment at all. It’s simply an account in which you can buy investments. Kind of like a savings account is an account in which you can not buy investments.

 

How it Works

What makes an IRA “a Roth,” are the tax rules.

 

The money you contribute to a Roth IRA must come from earned income after taxes have been taken out (a.k.a. from the part of your paycheck that hits your checking account). Once you’ve contributed money into a Roth account, you can use it to purchase investments that get to grow tax-free. Like a 401(k) and other retirement accounts, this money is intended for use in retirement. Therefore, you’re not allowed to withdraw money from a Roth IRA (except in certainly cases) until you’re 59 ½, or you’ll possibly face taxes and penalties. Head’s up, that’s not a reason not to use a Roth and in fact, it’s a good thing. Otherwise, we’d all be tempted to tap that money when we’re in a pinch and wreck our retirement savings. Do not be tempted to think of your Roth IRA as an emergency fund or a down payment!

 

READ SIMILAR | Should You Borrow From Your 401(k) For Your Wedding?

 

Roth IRA: Good To Know

 

1. THERE’S AN INCOME CAP

 

We refer to the Roth IRA a “use it or lose it” account because once you’re making more than a certain amount, as most future H.E.N.R.Y.s™ eventually will, you’re not allowed to contribute any new money to this account. The income limit changes from year to year but you can check the IRS’s website to stay up to date on what those limits are.

 

A Workaround

If your employer offers a Roth 401(k) there are no income limits there, so if you’re phased out of the Roth IRA because you make too much (first world problems) you can certainly look into using a Roth 401(k) to stash away after-tax dollars for retirement.

 

A Sneaky Loophole

If you’re right on the cusp of the income limit, you might consider increasing your pre-tax 401k contribution, thereby lowering your taxable income in that year and re-qualifying you for the Roth IRA!

 

2. USE IT TO COMPLIMENT YOUR 401K

 

There’s much debate about whether after-tax retirement contributions (like those to a Roth IRA) are better than pre-tax retirement contributions (like those to a 401k). Rather than get caught up in an impossible debate (because no one knows what the future holds for taxes), we suggest H.E.N.R.Y.s do both.

 

3. AUTOMATE THE MAGIC NUMBER

 

While you have until tax day to contribute to your Roth IRA for the previous year, we suggested setting up an automatic monthly contribution in the amount of $458. That’s the magic number to ensure you max out the contribution limit of $5500 each year. If you don’t have this wiggle room in your cash flow each month, you can obviously wait until a bonus or tax refunds hits, but you’ll miss out on a powerful investing benefit known as dollar cost averaging (more on that another day).

 

You can open a Roth IRA at almost any financial institution. Using a robo-advisor might be a good way to start until you’re ready to take it to the next level. And when you are, we’re ready for you.