Your Guide to Understanding Roth IRAs

While almost half of millennials have a 401(k) account, only one in four have a Roth IRA. What’s the deal? Y’all must not understand the benefits of a Roth IRA when compared to other retirement accounts, right?

A Roth IRA is a retirement account that can be funded with after-tax dollars and provides significant tax benefits (that’s the coolest thing about certain retirement accounts). You have to meet certain income requirements to pay into a Roth IRA, and there are a few tax rules that you’ll need to understand, but we’ve got your back here.

In this article, we'll discuss what a Roth IRA is and the basics of how it works as well as whether Roth IRAs might be right for you. We'll also include information about some of the rules governing these accounts and explain why they're so advantageous when used correctly. Let’s go.

What is a Roth IRA?

IRA stands for Individual Retirement Account. While most people have heard of both Roth and Traditional IRAs, there are actually quite a few other types of Individual Retirement Accounts, including SIMPLE IRAs, SEP IRAs, and more. The main difference between the accounts are the various tax advantages.

Today, we’re obviously going to be focusing on Roth IRAs. With a Roth IRA, contributions are not tax-deductible. However, as a trade off, your contributions grow tax-free, and once you’re in retirement, you can withdraw your contributions tax-free, as well. 

This is different from a traditional IRA in that when you pay into a traditional IRA, your contributions are deductible on your current tax return. However, once you withdraw your contributions in retirement, they will be subject to taxation based on the tax bracket you’re in during retirement.

How Do I Open a Roth IRA Account?

First thing’s first. You’re gonna want to make sure you’re eligible to contribute to a Roth IRA account. The first eligibility requirement is that you have earned income. The second is that, with that earned income, you can’t make more than $125,000 to $140,000 if you file your taxes as single or $198,000 to $208,000 if you file your taxes with someone else (note: these are the requirements for 2021, so be sure to check the limits each year if you’re not sure).

Now, if you make under that amount then it’s time to research where to open the Roth IRA account. Nearly every single investment company offers a Roth IRA option. If you currently have another retirement account with a company, check to see if they offer a Roth IRA plan as well. If not, then you’ll need to look around. Be sure to ask these questions:

  • What is the monthly management fee (if there is any)?
  • How much does it cost to trade?
  • What kind of investments do they offer within the account?

Also be sure to check out some reviews online to see how their customer service is. Once you’ve made your decision, you’ll need to have your personal information on hand to actually open the account. This includes things like a photo ID, your social security number, and your bank account information.

How Does a Roth IRA Account Work?

When you invest in a Roth IRA, it grows via two methods: contributions and earnings. As you continue to contribute to your account over the years, it obviously grows in terms of the balance. However, there is also the potential to earn compound interest on the money that is there. Just how much it can grow really depends on the investments you’ve made within the account.

When you’re deciding what to invest in with your Roth IRA account, you’ve got tons of options. The only things you can’t invest in are collectibles and life insurance. Generally, the best options for Roth IRA investments are the ones that generate highly taxable income, typically in the form of short-term capital gains or dividends and interest. Growth stocks can also be a great option, as long as you’re willing to be patient over the years.

Want to learn exactly what’s going to work for you? Download Wealth Stack and start learning with our pro investment courses (they’re all free!).

What Are the Benefits of Roth IRAs?

If you’re a younger worker then one of the biggest benefits of a Roth IRA is that you’re contributing post-tax dollars to the account. This means that you’ll be taxed at (likely) a lower tax bracket instead of being taxed at whatever your tax rate is when you’re 59 ½. 

Another one of the biggest benefits of a Roth IRA is the fact that you can withdraw contributions tax-free at any time. Note that we used the word contributions. This means that if you’ve contributed $15,000 over the years but have earned $2,000 on that money, you can only withdraw the $15,000 you directly contributed, not the earned money on that investment.

What Are the Drawbacks of Roth IRAs?

Unlike a 401(k), employers don’t offer contribution matching for most Roth IRA accounts. This can be a big drawback if you’re trying to directly compare the two. With a 401(k) that’s got employer matching, you have the potential to earn what is basically free money.

As well, because a Roth IRA grows with post-tax money, it doesn’t tend to grow as fast as a 401(k). And, contributions made to your Roth IRA won’t help you lower your taxable income, which can be a major drawback if you’re in a higher tax bracket.

Lastly, Roth IRAs have lower contribution limits than a 401(k). In 2021, the 401(k) contribution limit is $19,500 while the Roth IRA contribution limit is $6,000 (both figures are for those under 50).

Should I Convert My 401(k) to a Roth IRA?

To convert a 401(k) to a Roth IRA, you’d have to pay taxes on the money you’d like to convert into that new account. It can also get quite tricky as not all companies allow you to make a 401(k) conversion. 

If you think this is a good option for you, you’ll also want to be mindful of how much you’re converting in a single year. Because it’ll count as taxable income, the cost of that conversion could push you into a higher tax bracket and lead you to lose way more on taxes than it’s worth.

Should I Invest in Both a 401(k) & Roth IRA?

If you can, yes! However, we suggest maxing out your 401(k) contributions first, especially if your employer offers contribution matching. If they do, then work on trying to contribute the maximum amount to reap the benefits of your employer matching and then contribute to your Roth IRA.

Learn How to Make Smart Investment Choices

There’s a reason why only one in four millennials have a Roth IRA account; understanding the ins and outs of retirement accounts can get confusing. But, that’s what we’re here for!

Don’t know how to invest? We suggest downloading Wealth Stack. Not only will you be able to manage your investments (once you’re ready to make them), you’ll be able to learn how to invest for free. You can access numerous free video courses that will help you learn how to invest. Then, you can browse through our list of professional Speakers to learn straight from the pros. 

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