What is a Roth IRA and How Does it Work? [In Plain English]

This post is part of the #RothIRAMovement, designed to bring more awareness to the benefits of the Roth Individual Retirement Account or Arrangement (IRA). All credit goes to Jeff from GoodFinancialCents.com for starting the Roth IRA Movement and getting over 100 bloggers involved in this project.

What Is a Roth IRA and How Does it Work

Do you know about the Roth IRA?

Saving for your retirement is important.

You need to have money saved by the time you retire so that you can afford your expenses when you are physically and mentally unable to work.

When people talk retirement, the Roth IRA often comes up.

Rightfully so.

It’s an excellent tool to help you save more money for your retirement. I’ve used it in the past, in addition to my company’s 401K, to help me save for my own retirement needs.

Here are some characteristics of people who have a Roth IRA:

  • They may be just getting started with retirement investing and looking for a place to put their savings.
  • They may use a company 401K, but they are looking for an additional place to save.
  • They want to save a lot of money on taxes when they withdraw their retirement savings.
  • They want to have more control over their investment options and the investing fees they pay.
  • They want more control over their retirement savings withdrawals (i.e. use the money for a first home, major medical emergency, etc.).

Sound good? If you’re wondering what a Roth IRA is and how it works, I’m going to try to answer that for you in plain English below.

First Came the Traditional IRA

To understand the Roth IRA, it’s important to understand it’s predecessor, the Traditional IRA. The Traditional IRA and the Roth IRA are both tax-advantaged places to hold your retirement investments. Meaning, there is some type of tax savings involved. The U.S. Government created them so that you’d be encouraged to save more for your own retirement.

With a Traditional IRA, you place pre-tax dollars into the account and you don’t have to pay taxes on the contributions or earning until you start withdrawing the money at 59 and 1/2. In short, with a Traditional IRA, you get a tax break now, but you have to pay taxes on the earnings from the account when you retire and start cashing out.

This is almost identical to the way a 401K works. The major difference is control. With a 401K you are at the mercy of your employer’s choice of funds and expenses. With a Traditional IRA (as well as the Roth), you get to decide where to open the account, what to put in it, and if you want investments with low costs.

The Roth IRA Flipped Retirement Savings On Its Head

The Roth IRA is taxed just the opposite of the Traditional IRA and 401K. You place after-tax dollars into the account, and you don’t pay taxes on the contributions or earnings EVER, as long as the money is taken out in what is called a qualified withdrawal.

Because this account is so great, the government decided to put limits on it: both the amount of contributions that can be made each year and the amount of income a person can make and still contribute. In short, you can’t put an endless amount of money into the account and rich people need not participate. Be sure to review the contribution and income limits in more detail before starting up a Roth IRA.

It’s important to stress the concept that IRAs are simply places to hold your investments. They are not investments in and of themselves. You have to put something in them. Most people put some combination of stocks, bonds, and cash in their IRAs.

One last note about the Roth IRA: you have to go out and open one up for yourself. Your employer won’t do this for you. But this isn’t a negative. It’s a positive feature. Because you have complete control, you can decide where to open your Roth IRA, what to invest in, and you’ll never lose the ability to contribute if and when you change jobs.

Steps to Making the Roth IRA Work for You

So now that you have the basic concepts down, let’s look at the steps to making a Roth IRA work for you.

  1. Decide if you want to invest for retirement using a Roth IRA. In can be used in addition to, or in place of, a company 401K.
  2. Determine if you are eligible for the Roth IRA based on the income limitations.
  3. Open up a Roth IRA with a mutual fund company or discount broker.
  4. Decide what investments you want in your Roth IRA.
  5. Start making after-tax contributions to those investments within your Roth IRA.
  6. Continue making contributions as long as you want and are eligible.
  7. When you’re ready, start withdrawing funds tax-free.

Hopefully this post gave you a good idea of what the Roth IRA is and how it works. At the risk of repeating myself, it’s really a great tool to help you save much more for your retirement than you normally would. Taxes can really eat into your investment earnings. If you can take taxes out of the equation then you’ll be able to keep a lot more of your hard earned money.

If you’re looking for a good video explanation of the Roth IRA, look no further than this gem from Kevin @ Thousandaire.com:

Have a question about the Roth IRA? Fire away in the comment section below.

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Last Edited: May 13, 2013 @ 1:48 pm
About Philip Taylor

Philip Taylor, aka "PT", is a husband and father of two. He created PT Money back in 2007 to share his thoughts on money and to meet others passionate about managing their finances. All the content on this blog is original, and created or edited by PT. Read more about Philip Taylor, and be sure to connect with him on Twitter, Facebook, or view the Philip Taylor+ Google profile.

Comments

  1. nvannello says:

    And while you should really only take out retirement funds at the time of retirement, withdrawing funds from a Roth are much easier since you already paid taxes on that money. There are far fewer penalties and fees than withdrawing money from your 401K.

  2. Think they will ever start taxing what withdraw from a Roth IRA down the road ie Social Security??

  3. TheThrill says:

    are there any limits for contributions to a traditional IRA?  Can you do that in combination with a 401K?

    • There are limits on Traditional IRA contributions, yes. The rules are tricky, but for many earners you cannot contribute to both. See the rules here: http://ptmoney.com/traditional-roth-ira-income-limits/

  4. MoneyPlanSOS says:

    Good info PT. Now, how can you get all of this into a 2-minute video for #FLMonth? :)

  5. chase_dream says:

    very well described article. I think paying taxes now will be a great relief at older age when liabilities are far more 
     
    thanks for sharing,
    Karunesh 
    http://www.chase-a-dream.com/

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  8. Very insightful article! Since 2012 when Congress lifted the income restrictions on Roth IRA conversions, investors are now taking advantage of the benefits offered by a Roth IRA, like tax-free withdrawals during retirement!

  9. I’m afraid to contribute to my Roth IRA for fear that money will be lost if the economy tanks. I’m definitely not in the high income bracket & can’t afford to lose $$$. Am I misinformed? If I knew that my money would be safe, I would definitely contribute on a regular basis.

    Thanks for your help!