When it comes to setting up a retirement fund, the options can be overwhelming. After all, there are several ways to invest your money, including the highly popular Roth individual retirement account (IRA). But what exactly is a Roth IRA, and why do people always talk about it? Read on to learn everything you need to know about this type of retirement fund, including how it’s different from a traditional IRA, how to set up a Roth account and what you need to know about withdrawing from it when the time comes.
What is a Roth IRA account?
A Roth IRA account is a form of retirement savings built up by your financial contributions. It’s tax-free and is a good option for people who expect to be in a higher tax bracket at the time they retire.
“A Roth IRA is a tax-free retirement account where you pay taxes on the money now, so you don’t have to later. I joke with my clients that it’s the golden goose egg account of investing,” Britta Ferguson, a Senior Vice President (SVP) and Financial Advisor at Wealth Enhancement, told Woman’s World. “It’s one of the few places where your investments can grow completely tax-free—and when you retire, you can take the money out without paying a single dime of taxes again! This is how you create certainty and financial freedom in the future.”
Eric Croak, a Certified Financial Planner (CFP) and Accredited Wealth Management Advisor, adds, “don’t underestimate the ‘tax-free in retirement part’ of that.”
“You pay taxes on the money you put in, it grows and then you withdraw it tax-free in retirement,” he says. “A Roth IRA should be thought of as a savings account for the long term: the longer you can leave it alone, the more valuable it becomes.”
What is a traditional IRA?
A traditional IRA is a type of individual retirement account that allows you to put money into it without paying taxes on it. But once you take money out, you will begin to pay taxes on whatever you withdraw.
How is a Roth IRA different from a traditional IRA?
Despite the fact that Roth and traditional IRAs both help people retire, there are quite a few differences between the two. The biggest one, of course, is that Roth withdrawals are tax-free, while withdrawals from a traditional IRA are not.
“A lot of times you hear people talk about whether or not to invest in Roth vs. traditional, but if you’re investing for the long-term in a Roth, it’s absolutely a big deal when it comes to 30 years of of tax-free compound growth on $7,000 [the maximum contribution] a year,” Croak explained. “It’s designed for those who value flexibility in retirement and hate the idea of projecting future tax brackets. Plus, truth be told, after you use a Roth properly, it’s hard to go back to other options.”
How to set up a Roth IRA account
It’s not hard to do, says Croak. “Fidelity, Schwab, Vanguard—whichever brokerage house you use, most people can set up an account easily,” he says. “The most common mistake people make is they put the money in there and they just leave it in cash. A Roth IRA is not an investment—it is a wrapper, a vessel. Now you have to decide what that money needs to be invested in. It is not an investment strategy in itself. If you fund a Roth IRA and leave it in cash, you’re defeating the purpose.”
“It’s a long-term growth account and it’s important to treat it that way,” says Croak. “So whether you invest in a total market index fund, dividend stocks, REITs [Real Estate Investment Trust] or some combination, look for low-cost investments with a lot of upside [more aggressive, weighted toward stocks, since you want this account to grow]. The whole point of a Roth is not paying taxes on the growth, so don’t stuff it with CDs [Certificates of Deposit] or cash equivalents. You’re not playing defense with a Roth IRA— you’re playing offense, and the ball is tax-free compounding.”
How to withdraw from your Roth IRA
“Withdrawals are where the Roth IRA sets itself apart, and where people get into trouble if they have not been paying attention,” Croak says. “You need to be in the account for five years and over the age of 59 1⁄2 before your gains are tax-free, but your contributions [separate from your earnings] can be withdrawn at any time penalty-free. So there is some flexibility…but if you use it like an emergency fund [taking money out before retirement], you have neutralized its true advantage.”
“Honestly, I think this hybrid nature—long-term compounding and short-term access to principal [the original amount you invested]—is one of the primary reasons Roth IRAs are such an effective vehicle for both ‘regular’ investors and high-net-worth families.”
