Roth IRAs: Everything You Need to Know

Allison Kade
Posted

You may have heard of a Roth IRA, but what exactly is it? And how does it differ from a regular IRA?

We sat down with David Blaylock, a Certified Financial Planner™ with LearnVest Planning Services, to learn the ins and outs of the Roth IRA—and whether it’s right for you.

What Is a Roth IRA?

IRA stands for “individual retirement account,” and it’s a brokerage account that’s specifically designated to fund your retirement. As with any brokerage investment account, it allows you to trade securities. But unlike other brokerage accounts, IRAs have tax benefits, and the difference between traditional IRAs and Roth IRAs comes down to those benefits.

“With a traditional IRA, your contributions are usually tax deductible, meaning that the amount you put into your IRA is exempted from your taxable income,” Blaylock says. “But with a Roth IRA, you pay taxes on the money that you contribute before it enters the account.”

So if you make $50,000 this year, and contribute the annual maximum of $5,500 to your traditional IRA, you’d only be taxed on $44,500 of your income and therefore pay less in taxes. Of course, this doesn’t mean that you’re completely off the hook for paying taxes on that $5,500—you’ll have to pay them later, when you withdraw the money from your account 20 or 30 years down the road.

It sounds like no big deal, right? You either pay taxes now with a Roth IRA or pay taxes later with a traditional IRA. But, in fact, there’s a huge difference because your IRA is a brokerage account and that money is growing as we speak. If you open a traditional IRA, and withdraw that money later, you’ll be taxed on your contributions … and your investment earnings.

Let’s say that you contribute $150 per month for 20 years, which comes out to $36,000. If you earn 7% returns, those contributions could morph into $78,000—over half of which would be your investment earnings. With a Roth IRA, you only pay taxes on that $36,000—and then you’re done. With a traditional IRA, you’d be taxed on the entire $78,000 sum when you withdraw.

RELATED: The 7 Biggest Retirement Mistakes Financial Planners See

How Is an IRA Different From a 401(k)?

There is a third very common type of retirement account, although it doesn’t have “IRA” in the name: a 401(k). “A 401(k) is a retirement account that’s usually set up through an employer, while IRAs are created and managed by an individual,” Blaylock explains. Also, when compared to IRAs, 401(k)s tend to have limited investment options.

With a 401(k), some employers “match” your contributions to a certain point, so if you contribute, they’ll contribute some (free!) money too. “And you can contribute to a Roth IRA and a 401(k),” Blaylock adds. “So if your employer doesn’t match your 401(k) contributions, you may want to think about whether you’d prefer to bypass the 401(k) and focus on maximizing your Roth IRA instead.”

There’s one other type of account to consider: Roth 401(k)s, which work the same way as Roth IRAs—they tax you upfront, sparing your future earnings from the taxman. Although Roth 401(k)s used to be pretty rare, they’re growing in popularity. If your employer does offer this option, read our guide to Roth 401(k)s. If your employer doesn’t offer one, the only way to open a Roth 401(k) is if you’re self-employed.

RELATED: Should I Roll Over My 401(k)?

  • Rob_Drury

    IRA stands for “individual retirement arrangement,” not “individual retirement account.” While this may seem like semantic nitpicking, it actually highlights that the IRA itself is not the vehicle in which one invests. In fact, an IRA may be funded by almost any type of financial asset except a traditional life insurance policy. This is an important distinction in understanding that the IRA is a tax-advantaged “shell;” and it, rather than the investment account, is what is offering the tax advantage.
    Rob Drury
    Executive Director,
    Association of Christian Financial Advisors