How Does a Roth IRA Work? Everything You Need to Know (and More)

Updated 04/29/19
how does a roth ira work
The Chriselle Factor

Deciding how to invest for retirement is right up there on our list of painful things we must do (it’s right next to—ugh—choosing our healthcare plan for the coming year). During the investment process, questions pop up: How does a Roth IRA work? Which type of funds should I invest in? What is my tax bracket? But perhaps our favorite question is when we get asked, “Well, when do you want to retire by?” It’s like “Um, next year?” (Just kidding… kind of.)

One mistake many people make when planning for retirement is only contributing to their company-sponsored 401(k), not knowing that they actually have other options. Employers have several sets of funds that you can invest in when they offer you benefits. (Funds are diversified, generally low-risk holdings in stock.) Plus, when you invest through your company, your employer has the option to match up to a certain percentage of your contributions. So, you ask, if your company is offering you all this, why would you invest in a Roth IRA? Well, it’s time to listen up as we break down exactly what a Roth IRA is and how it differs from other investment options.

WHAT IS IT?

This particular type of retirement account was introduced in 1997 and allows for your contributions to be taxed on the way in and not on the way out like a 401(k) would. This is especially beneficial if you expect to accrue a significant amount of interest on your earnings over time. A Roth IRA is not offered through your employer, so you’ll have to set this account up yourself, but it’s so simple to get started (more on that below).

WHO QUALIFIES?

Anyone—even children—who has income ais eligible, as long as they earn no more than $131,000 if they're filing individually or $193,000 if they're filing jointly. If your employer offers you a 401(k), you can diversify and set up a Roth IRA in addition to that. If you happen to be self-employed, a Roth IRA is a great option to make sure you’re saving for retirement. By the way: You can contribute up to $5500 a year (once you hit 50, you can invest an extra $1000 annually).

How do you set it up?

How does a Roth IRA work? Don’t get intimidated! First, you must pick which company you’ll set it up through: Your options include Vanguard, Betterment, and Wealthfront, although there are others. Once you add your funds, you’ll have to choose your investments (this will probably take the longest amount of time). If you’re not thrilled with the investment options through your 401(k), a Roth IRA is where you can get creative and do some real research.

What are the benefits?

There are benefits and downsides to any form of retirement account, but a Roth IRA has a lot of positives. Firstly, as we mentioned, since you’re taxed on the way in, you can actually be relieved of paying a ton of money in interest when you withdraw money in retirement. It also allows you take money on the principle out pre-retirement, and first-time homebuyers can actually use up to $10,000 of it tax-free (yes, you read that right: no penalty). Another key element, which you may not be as concerned with now, is that you are never required to withdraw money from the account, so it’s easy to leave your investments to your heirs.

WHAT IS THE TAKEAWAY?

A Roth IRA is a unique type of retirement account you should consider using in conjunction with your 401(k), or alone if you happen to be self-employed. Its salary requirements are fairly inclusive, and it is less stringent than other types of investments when it comes to withdrawing money before retirement. It’s always wise to diversify your savings, so keep that in mind when making any decisions.

What type of retirement plan do you have set up? Did you teach yourself how to save for the future? Let us know.

Up next: how to make more money without switching jobs.

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