What exactly is a Roth IRA?
A Roth IRA is a valuable tool for retirement savings, Hamm writes, so it’s well worth spelling out what it is in the clearest terms possible.
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“What exactly is a Roth IRA? I understand that it’s a way to save for retirement but the Wikipedia entry is basically gobbledygook to me. I basically understand what my 401(k) is so how does it compare?“
A Roth IRA is a valuable tool for retirement savings, so it’s well worth spelling out in the clearest terms possible so that everyone understands what it is.
A Roth IRA is a type of Individual Retirement Account (that’s the IRA abbreviation, of course) that allows most individuals to save for retirement on their own with or without a 401(k) plan at their workplace. Someone working at Home Depot could start a Roth IRA, as could a janitor or a computer programmer working for the government.
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The best way to think of a Roth IRA is like a special savings account. Just like a savings account, you open a Roth IRA at a financial institution. Just like a savings account, you add money to it, ideally on a regular basis. Just like a savings account, it builds up money over time.
The main restriction on starting and adding money to a Roth IRA is income. A single individual needs to be making less than $112,000 a year (this number varies from year to year, drifting upwards) and a married couple needs to be making less than $178,000 a year (again, this number varies somewhat and gradually drifts upward) in order to be able to fully contribute to a Roth IRA. You also need to be earning an income of some sort to contribute – you can’t contribute more than you earn. There’s also an annual contribution cap of $5,500. (There are a few specific exceptions to these numbers, but they’re minor and mostly allow for more contributions in a few cases.)
The other big restriction on a Roth IRA is withdrawals. In order to make unrestricted withdrawals from a Roth IRA, you must be 59 1/2 and have the account open for five years or more. If you don’t qualify, youcannot withdraw any money you’ve earned in the Roth IRA without taking a significant tax penalty. You only want to do that in a truly dire situation.
However, if you are over 59 1/2 and have had the account for more than five years, there are no income taxes whatsoever on anything you take out of a Roth IRA. When you take money out of a savings account, you owe income tax on the interest. When you eventually take money out of your 401(k), you’re going to owe money on everything you take out. With a Roth? You owe no income taxes once you’re of retirement age.
Remember, of course, that you’re putting money out of your take-home pay into the account. With a 401(k), that money comes out of your pay before taxes are taken out, meaning you actually pay those taxes later when you’re retired. With a Roth, you’ve already paid the income taxes when you received your paycheck.