What Is a Roth IRA and How Does it Work?

What Is a Roth IRA and How Does it Work? March 27, 2012

If you don’t know what a Roth IRA is, you’re not alone. Recently a friend of mine who is a financial planner spoke in a classroom of graduating college seniors and asked how many of them had heard of a Roth IRA.

Not a single hand went up.

That’s when he decided to start a movement – a Roth IRA movement. There’s obviously a gap when it comes to public education and personal finance, so this article is meant to help fill that gap. For even more awesome articles about Roth IRAs, visit Good Financial Cents for a complete list of article in the Roth IRA movement.

$5,000 Cash Giveaway

To sweeten this article up even more, Jeff and a group of bloggers are giving away $5,000 to fully fund a Roth IRA.  How cool is that?!  It’s sponsored by IRAMarket.com and you can enter on their facebook page – click the link to be directed to their page.

First Off…What is a Roth IRA?

The term IRA stands for Individual Retirement Arrangement, but most people call it an individual retirement account. It’s a way for you to legally launder money from the government. ;) In all seriousness, the IRS allows us to save for retirement and gives us tax breaks to do it. Here are the two most basic types of IRAs:

Traditional IRAs – You set aside pre-tax dollars, and pay taxes on the withdrawals after age 59 ½ (both interest earned and original principal contribution).

Roth IRAs – You set aside after-tax dollars, and pay no tax on the withdrawals after age 59 ½ (both interest earned and original principal contribution.)

Read this article for a thorough explanation of a Traditional IRA.

How Does a Roth IRA Work?

The Simplicity of Opening a Roth IRA

The biggest hurdle for most people I’ve met is that they don’t know where to open a Roth IRA, so they don’t bother. There are literally two pages involved with opening an IRA and most of it is you writing out your name and personal information – like your address and phone number…pretty basic stuff.

Choosing a brokerage to start an IRA through isn’t rocket science either. A lot of great brokerages will open your Roth IRA online in a matter of minutes, so you really can get started right away. Here are some recommendations for places to open a Roth IRA:

Making Contributions to a Roth IRA

Ok, so now that you have it opened, you can start making contributions to it. The absolute best practice is to set up an automatic draft from your bank account so that it pulls $100 a month or so from your bank account into your Roth IRA.

Contribution limits: If you are under age 50, you can contribute $5,000 a year to a Roth IRA. If you are over age 50, you can contribute $6,000 a year to a Roth IRA.

It should also be said that the IRS places an income restriction on Roth IRAs, meaning that if you earn more than a certain amount of money, you will not be able to contribute to a Roth IRA. You can still contribute to a traditional IRA, but just not to a Roth IRA.

Here’s an article that gives a full explanation of Roth IRA Contribution Limits and Income Restrictions.

Investing Your Roth IRA Contributions

Every brokerage account has investment options. Don’t let them overwhelm you. If the explanation of each investment option is confusing, call or email them for some guidance.

Look for low fee investments like index funds. These will give you the exposure to the stock market and often have the lowest expense ratios.

Roth IRA Rules to Remember

Remember, when you open a Roth IRA, you’re establishing a retirement account. You can take advantage of the tax free withdrawals if you follow the rules set by the IRS. While it’s not recommended, there are ways that you can access the money in your Roth IRA early. In most cases, the money you draw early will have a 10% penalty attached to it and you might even jeopardize the tax-free withdrawal status of the earnings. Here’s a full explanation of Roth IRA early withdrawal penalties.

A Roth IRA is one of the best ways to save for your retirement. Start it early and you’ll see the power of compound interest in action.

Have you started a Roth IRA? What are you waiting for?

Start an IRA with Betterment today.

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