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It’s the new year. The season of exorbitant spending is over. This might be the worst possible time to pitch the importance of investments. But, I’m going to do it anyway. Because it’s really that important. We’re going to talk about the Roth IRA. Maybe you’ve heard of it, but don’t know what it really is. Or why it’s important. Maybe you’ve never heard of it, ever. Or you’ve heard of it and are wondering, “Do I really need a Roth IRA?”. The terms “retirement fund” or “401k” may sound more familiar. Maybe you were like me. I pretended to know everything about it and just lumped all these terms into one.
Me: “Oh yes…the Roth IRA? Yup. Important. Future. Retirement. All those things.”
Unimpressed Friends : “Do you even know what it is…?”
Me: “…Hey wasn’t that economics test super difficult yesterday?”
But have no fear! After reading this, you’ll be able to impress your friends (unless they read my blog too)! I think Roth’s are important, especially if you’re young (subjective term. Don’t get mad old people. Old is also subjective.), I’d suggest starting one yesterday. But since that’s impossible, I recommend reviewing your finances and making it a priority to start one ASAP. There are scenarios where this isn’t the case. You might even be unable to start a Roth IRA if you don’t meet certain qualifications. But for most people, the Roth IRA will be a very worthy investment.
What is a Roth IRA?
I learned about the Roth IRA back in college. I heard about the Traditional 401k first. But only because that’s a term that gets thrown around everywhere. To me, it felt like a Roth was a less important version of the 401k. Like an off-brand cereal or something. If I had my Apple Jacks, why would I even consider Apple Orbits? (Yes, that’s a real knock-off brand name).
An IRA stands for Individual Retirement Account (add that to your list of personal finance acronyms!). It’s a retirement account that you set up directly with a broker. Simple enough. Well, until you realize there’s actually two types of IRA’s. One is a traditional IRA. The other is the Roth IRA.
What’s the difference between a Roth IRA and a Traditional IRA? Well, there are plenty. And I’ve made a handy chart below to help identify some of the similarities and differences. The same differences can be applied to a Roth 401k and a Traditional 401k. Of course, that would be dealing with a company 401k, rather than an individual retirement account.
As you can see, there are several differences between the two. Traditional IRA’s have some age requirements and mandatory withdrawals, while Roth IRA’s have no age restriction but have some income guidelines.
But the key difference between these two retirement accounts is the way taxes are handled. That’s the critical part to understand. And this is also what separates the Roth from your traditional 401k. Tradional IRA’s and 401k’s incur taxes later, while Roth’s deal with them now. Why is that important? Let’s see.
Taxes, Taxes, Taxes
Unless you’re an accountant (props to you), no one really likes dealing with taxes. Or really tries to understand them. Well, believe it or not, understanding your tax benefits regarding your IRA is critical. You can set yourself up for success by choosing the right type of retirement account for you. And as I mentioned early on, the Roth IRA is a great choice for most young people, because of the way it works.
You incur taxes up front. You’re using your post-tax income to invest in the Roth IRA. So yes, you will not receive any tax break for investing in a Roth IRA. But this can greatly benefit you down the road.
A simple deduction can be made from this: Roth IRA’s are more effective if you believe that you will be making more money in the future. Why? Simply put, your tax rate will most likely be higher when you are making more.
If you believe your tax rate will be higher now than your future tax rate, then a traditional 401k will be a better choice, since you will be investing your pre-tax income now. The tax break you incur in the future would theoretically be lower.
Check out this (very) simple example:
You’re 22. You’re contributing 5500 a year. And we’re also capturing the tax break advantage that the 401k offers you and reinvesting that. The only thing different is the current tax rate vs. retirement tax rate. See how much of a difference that plays? That’s a $238,000 difference at retirement. Obviously, this is just to put into perspective the importance of understanding the tax differences between the two retirement accounts. I understand we’re making plenty of assumptions here, so these numbers are just for show.
How Do I Start an IRA?
Well, an IRA is an investment portfolio. You can easily start it by choosing a provider (preferably with low exchange fees), such as Vanguard (which I use), Fidelity, or Charles Schwab. Creating an account is fairly straightforward. But if this is your first time dealing with investments, you may not be familiar with how to choose a proper investment portfolio.
When you start your IRA, you’ll have access to a lot of different options on what to invest. Index funds, ETFs (exchange-traded funds), stocks, bonds, etc. It’s important to understand what makes up a good, balanced portfolio.
A commonly suggested guideline is to have a 3-fund portfolio. Here’s a simple graphic that can help explain what it is:
Now, even though those circles are the exact same size (trust me, I made sure they were. I think I might have OCD), you don’t necessarily have to invest in them equally. That will depend on how risky you want to be. And how old you are (hmm…this seems to be a common trend in this post).
If you’re young, you will typically be able to mitigate risks better. Markets will adjust and correct themselves over time. Warren Buffet invested in the S&P 500 (an index fund) and outperformed just about everyone. It’s been said everywhere, but it is true: time is your best friend when you’re young.
And on a high level, this is what you need to remember. Stocks are risky. Bonds are safe. And the critical thing to do here is to diversify. Especially if you have no idea what you’re doing. That helps mitigate risk. A lot.
But there’s also an option to have this whole selection process “automated”, if you’re not feeling too confident. There are Target Date Funds that you can invest in. You can estimate what year you will retire and invest in these funds accordingly (Example: Vanguard Target Retirement 2055 Fund). As time goes on, adjustments will automatically be made for you. It may start you off with more stocks (risky), and shift to more bonds (safe) as you get older.
When’s The Best Time To Start a Roth IRA?
I hate to sound like a broken record. But if you’re young, you should REALLY consider starting one. However, there are a few other things to keep in mind.
Roth IRA’s are investments. That means they shouldn’t be the first thing that you put your money towards. Here are a few things to consider before starting your Roth IRA investment:
- Emergency Fund. I’ve stressed this before. And I will again. This will save your finances in the near future. You don’t want to fund an IRA and then be forced to withdraw and incur penalties just to deal with an emergency.
- Employer Match 401k. If your employer offers you a match on your 401k deposit, contribute up to the max. That’s a free 100% return, something your IRA will not be able to compete with.
- High Interest Debt. If you’ve got high-interest debt, you’ve got to pay that off first. No use carrying credit card debt with 22% interest when you’re making a rough average of 7% on your IRA.
Having said that, if you do have the funds to start an IRA, it will be a wise investment for you down the road. When you have both a Roth IRA and traditional 401k, you’ll be covered regardless of your tax situation.
The deadline for contributing to a Roth IRA is the tax deadline of the next year. So for example, the tax deadline is April 17, 2018 for this year. If I make any investments from now until then, it can still count as a 2017 contribution. So even though the annual contribution limit is $5500, you can actually still invest in last year’s contribution, and still put another $5500 for this year (2018). That reminds me…I still need to do this too.
I’m Ready! Anything Else I Should Know?
A few more things to remember about the Roth IRA:
- There IS an income limit. This changes each year, but make sure you (or your household) fall into the appropriate limit in order to make contributions.
- Penalties are real. Withdrawing before 59 1/2 years old can get you some pretty hefty penalties. You may have to pay tax on your IRA earnings in addition to a 10% early withdrawal fee. Not fun.
- Exceptions are also real. To counter the point above, there are exceptions. There are plenty of exceptions, so check out this article to learn more (if you do plan on withdrawing early).
There are definitely other topics that we can look at in the future. There’s something called the Backdoor Roth IRA, which allows you to bypass the income limit. And there are certainly other hidden conditions and perks of having a Roth IRA that weren’t represented in this article. If interested, definitely check out this article for more details and info!
Are you currently investing in a Roth IRA? Do you regret not investing in one? What are other important things to keep in mind that may not have been mentioned in this post?
Thanks again for following along and be sure to comment below!