When it comes to investing, people have lots of different decisions to make:
What brokerage should you use?
Should you invest in ETFs or individual stocks?
When is the right time to buy or sell?
But one of the earliest and most important decisions every investor has to make is what type of investment account they should open.
Between tax laws, contribution and withdrawal limits, and eligibility requirements, there are different types of investment accounts that suit different investors. But the Roth IRA is one of the most powerful investing tools out there, and for most people reading this article, it should be at the top of your list.
Let’s talk about why.
What’s a Roth IRA?
A Roth IRA is a special type of IRA (individual retirement account) that allows you to invest your money now and pay zero taxes when you withdraw it in retirement.
Roth IRAs differ from traditional IRAs in that contributions made to traditional IRAs are tax deductible, meaning that your contributions let you lower your taxable income (and therefore the taxes you pay) this year and instead pay taxes on your withdrawals in retirement, using whatever tax bracket you’re in at that time.
With Roth IRAs, on the other hand, contributions are made with after-tax dollars. You earn your income this year, pay taxes on it without a special deduction, and then use that money to contribute to your Roth IRA. Then, when you make withdrawals in retirement, your money is completely tax-free.
What’s the Catch?
There always is one, right? While getting to withdraw your money tax-free in retirement is pretty nice, there are some restrictions on Roth IRAs that will lock your money up more than it would otherwise be in a regular brokerage account, or even disqualify you from contributing entirely. Let’s take a look at some of the basic rules.
Roth IRA Eligibility
If you make more than $140,000 a year, you cannot contribute to a Roth IRA.
If you make between $125,000 and $140,000, you can make a partial contribution.
If you make less than $125,000 you can make a full contribution. These numbers are different for married couples who file their taxes jointly.
Roth IRA Contribution Limits
The IRS places limits on how much money you can contribute to a Roth IRA every year. For 2021, the maximum contribution is $6000.
If you’re over 50 years old, you can contribute $7000.
You can spread your contributions out over multiple IRAs if you have them, but your total contributions to both your traditional and Roth IRAs cannot exceed the maximum contribution limit.
Roth IRA Withdrawal Rules
Since you’ve already paid taxes on your contributions to your Roth IRA, you can withdraw your contributions anytime without penalty.
If you want to withdraw your earnings, however, there may be consequences if you don’t meet certain criteria.
For example, if you’re not at least age 59½, you aren’t using your earnings to help you purchase your first home, and you’re not disabled, you will be subject to both penalties and taxes on those withdrawals.
Is a Roth IRA Right for Me?
As we know, the main difference between traditional and Roth IRAs are that traditional IRAs defer your taxes until retirement, while Roth IRAs make you pay your taxes now and let the money grow tax-free.
So, the main calculation you will have to make when deciding between a traditional and Roth IRA is whether your tax rate will be lower now or in retirement.
For most young investors who are still in school or even starting their first jobs, a Roth IRA will be a great choice, because they are probably in a lower tax bracket now than they will be in retirement.
For investors who make a bit more money, making that estimation might be a little more difficult.
For the young investor, the only thing more important than opening a Roth IRA is making sure you’re making contributions to your 401(k) at work and maximizing the amount of your employer’s matching. (Check out our article on 401(k)s here!) Besides that, a Roth IRA is a very powerful tool for those investors who want to be able to keep their money growing completely tax-free for retirement.