Understanding the Roth IRA

Tuesday, June 3rd, 2008

In my last post, Save Early and Become a Millionaire, I commented on how a 16 year old can go from a pauper to a millionaire by saving up some cash and investing it in a Roth IRA over 40 years. I wanted to do a little more research and find out exactly what an IRA is. So this is what I found out…

IRA stands for Individual Retirement Account. It’s a retirement plan that lets you contribute up to a certain amount per year and provides tax advantages too. After you establish the account you can invest in bonds, stocks, mutual finds and CDs just like a regular cash account. There are a few different IRAs but the two most common types are Traditional and Roth. Roth IRAs were created to encourage people to save for retirement by offering significant tax breaks.

So what’s the difference between Traditional and Roth? Good question. Now listen up, this part is important. With a Roth IRA you pay income tax, and then make your contribution with after tax dollars. There are no taxes when you make a withdrawal. With a Traditional IRA you get a tax deduction, which lets you deposit before tax dollars then when you make contributions but you also pay income tax on the entire amount of your withdrawals. Roth has the extra advantage since taxes will probably rise in the future; paying taxes now rather than later will save you money in the end.

How do I start a Roth IRA? Any number of providers would be happy to help you start a Roth IRA, including banks, brokerage firms and insurance companies. But the first thing you should do is see if you are eligible. There aren’t many restrictions but the big one that stands out is your income; you can’t make more than $100,000. Next decide which investment will be the best for your Roth. Finally select a provider and create the account. I myself will be going with E*Trade’s Roth IRA account. The E*Trade account features no account fees or minimums, robust investing opportunities and advisors to help you with asset allocation strategies. Probably the best option if you just want to sit back and not worry about what to invest in.

What if I want to make a withdrawal? Firstrade says this:

Before the age of 59 1/2, withdrawals from your IRA account would incur a 10% penalty on top of any taxes owed. However, there are several exceptions to be able to withdraw from an IRA without penalty.

With many ways to save and invest your money out there, a Roth IRA is the simplest - and potentially the most effective - account to save for the future. The Roth IRA has the advantage of getting taxed only once, compared to twice or more with a regular investment account.

If you’re interested in learning more about Roth IRAs or IRAs in general, How to Start a Roth IRA will tell you in depth about the process of starting a Roth IRA. Firstrade also has a comprehensive IRA FAQ guide for beginners.

If you have an IRA already, please share your advice on the matter, or if you’re starting an account, share your experience in the comments.

Bookmark to: