What’s a Roth IRA?

What’s a Roth IRA?
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Roth IRAs are a great starting place to get your feet wet in the investing world. But what is a Roth IRA and why would you want to invest in one? These are great questions and in this article I will address both in a digestible level of detail. Let’s begin!

What’s an IRA?

Let’s start with defining an IRA. An IRA is an acronym for “Individual Retirement Account”. Which is, obviously a retirement account for an individual. This is just a bank account that you can put money into. But unlike your checking account which is used to buy beer and hamburgers, this account is used to purchase financial assets that (ideally) appreciate in value over time. There are two types of IRAs – Traditional and Roth. I won’t go into detail about Traditional IRAs in this article but a simple duck duck go search will give you a wealth of information!

Okay, so we know what an IRA is now. Simply an acronym for “individual retirement account.” But what about Roth? What does that mean?

What’s a Roth IRA?

Roth is simply used to describe the type of IRA. And it dictates the taxable status of the account. Roth accounts are funded with money that you’ve already paid taxes on (i.e. you don’t get a tax break for contributing to these accounts) but when you decide to pull your money out, it can be taken out tax free.

A good rule of thumb is Roth IRA’s are the right type of IRA for you if you fall into either of the below categories:

  1. I believe my income will be greater in the future than it is now.
  2. I believe that tax rates will increase in the future.

Roth IRA’s are used by people who want to “Lock-in” their tax rate. You pay tax today and then never again on that money. Or, you can “roll the dice” so to say and bet that you will be in a lower tax bracket in the future when you want to pull your money out of your Traditional IRA. There’s plenty of debate on which is the right approach.

So! Now we know that a Roth IRA is a retirement account for an individual which is funded with money you’ve already paid taxes on. That’s it! It’s that simple! But, now we must address a more important question: “Should you invest in a Roth IRA?

Why invest in a Roth IRA?

Now that we know what a Roth IRA is, the next logical question is why the heck would we want to invest in one of these. Personally, I think the benefits of investing in a Roth IRA boil down to a few key points: Control, Tax, and Simplicity.

Control

Roth IRA’s are great because anyone can open one up and you don’t need an employer to sponsor it. Anyone can go online, find a broker that offers this type of account, sign up, and start contributing! I like this account because it puts the power in the hands of the individual and you don’t have to have an employer get involved. It’s also a pain in the butt to roll over 401K’s each time you switch employers (more on 401K’s in another post). But with Roth IRA’s, you never have to switch because you changed jobs! You set the account up once, set up auto investing, and boom! You can now proudly say that you are doing something big for your future.

Tax Advantaged

The US Government created this type of account so that people like you and me can fund our own retirements. What’s great about this account is, the money that we put into our Roth IRAs can grow and be withdrawn tax free. On the other hand, if you utilized a Traditional IRA, any distributions would be taxed at your income tax rate. Again, the idea here is, you “lock-in” your tax rate and don’t have to worry about tax rates going up or moving up tax brackets in the future.

Simplicity

I love Roth IRA’s because they are easy. The same account that you use to pay for your In-N-Out burger can be sent to an account and grow tax free for your retirement. Just find an institution that offers IRA’s (I use vanguard), open an account, and put money into it. Obviously you’ll want to decide what to actually buy with that money so that you outpace inflation and what not. I love index funds for this kind of situation. Roth IRA’s are just easy to use. It’s just you, your money, and the institution that offers them. That’s it!

It’s worth noting here that the government only allows us to put up to $6,000 per year into our IRA account. For some, that’s way more than possible right now. For others, that’s nowhere near enough. Pro Tip: For you married people out there, both you and your spouse can have your own IRA account. This effectively means that as a family, you can actually be stashing away $12,000 into a tax free growth account like a Roth IRA which is HUGE.

If you do nothing else, do this.

Seriously, if you do nothing else, just set up a Roth IRA with automatic investments. Doing this alone will put you so far ahead of the rest of people. You don’t have to hit the contribution limit. You don’t have to be a stock market expert. Regularly contribute to these funds and have the funds automatically buy a big index fund and you will have made a huge step towards a happy and stress free financial future.

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