What Exactly Is A Roth IRA?

Roth IRA’s (Individual Retirement Account) were introduced in 1997 by Senator William Roth. 15 years later, there is still a lot of confusion about what they actually are, and who should use them. Prior to 1997, there were only IRA’s (now called Traditional IRA’s to differentiate them from Roth IRA’s). You could put money into a Traditional IRA each year, and deduct your contribution on your tax return. This meant you didn’t have to pay income taxes on your Traditional IRA contribution. The money would then grow tax deferred, so you didn’t pay taxes on the growth every year. When you pulled money out of the Traditional IRA, you were taxed at your personal tax rate. This was a pretty good deal, because instead of paying taxes the year you earned the money and made the contribution, you were basically able to invest the taxes and allow it to earn money in the market.

Roth IRA’s were introduced to allow consumers to switch the way they were being taxed. With a Roth IRA, you have to pay taxes on your contributions, but the money is then able to grow tax free. When you take money out of the Roth IRA, it won’t be taxed. The downside is you don’t get to invest (and get a return) on your tax dollars. There are other differences between Traditional and Roth IRA’s but we will get into those in a future post.

The most common question people ask is who should be using a Roth IRA? For many of my clients, the Roth IRA makes the most sense. If you are in the same tax bracket when you take money out of an IRA as you were when you contributed the money, then it doesn’t matter if you use a Roth IRA or Traditional IRA; your final balance will be the same. The only time I recommend Traditional IRA’s for clients is if they know they will have a much lower tax rate when they are taking money out of their IRA than they have today. Even if you will be in the same tax bracket in the future, the other benefits of the Roth IRA make it much more appealing than the Traditional IRA.

A common misconception about Roth IRA’s is people believe they are an investment. I frequently hear “I am going to invest in a Roth.” Think of an IRA (Roth or Traditional) as a bank account that the government has simply decided to tax differently, and has put some strict rules in place affecting how you can take your money out. Once you deposit money into the IRA, it will simply be invested in cash. You have to actually purchase mutual funds, stocks, or bonds in order to earn a return.

One major complaint I hear about Roth IRA’s is a general lack of trust in the government to let them grow tax free. There is fear that in 20 years, the government might come along and say “We are sorry, but we lied… you have to pay a 25 percent tax on your Roth IRA.” If this were to actually happen, it would have made more sense to use the Traditional IRA, but then again, who’s to say the government will leave them alone? I can’t predict the future, but I do know that the government would be angering A LOT of investors with a move like that.

So how do you open a Roth IRA? If you want to do it on your own, I recommend using www.Vanguard.com, but www.tdameritrade.com and www.schwab.com are good options as well. Another option is the find a fee-only financial planner that will help get you started, and will give some investment recommendations as well. Simply open an account, and start saving! You can put $5,000 into your Roth IRA this year ($6,000 if you are over 50!). If possible, I highly recommend putting the maximum amount into your Roth IRA this year.

If you take nothing else away from this post, know that Roth IRA’s are AWESOME. Roth IRA’s (and now Roth 401(k)’s) give you the ability to pay the taxes now, and get tax free growth for the rest of your life. That is a pretty sweet deal.

So what do you think? Do you already have a Roth IRA? If not, have I convinced you to go open one? Let me know what you think in the comments section!

Alan Moore is a fee-only financial planner and founder of Serenity Financial Consulting in Shorewood WI. Follow him on Twitter @R_Alan_Moore, or contact him at alan@serenityfc.com or 414-455-5313. You can also visit his website at www.SerenityFC.com