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What is a Roth IRA? How does it work? What do I need to know?

I’m not sure if I’ve made this clear yet, but I'm slightly obsessed with saving for retirement. And one of my absolute favorite vehicles at my current stage in life? The Roth IRA.

Now let me be clear. There are many many other short-term and mid-term goals you should be putting your hard earned dollars to. Think: your “Oh Shit Account,” a wedding, some miniature versions of you, future education… The list goes on.

But retirement is a favorite topic of mine because I know most of my peers aren't thinking about it.

And if you've ever looked into how compound interest works (basically like breeding rabbits, but with your money) you would see why it's so important for us to start thinking about and investing for the long-game, as early as possible.

You’ve heard about a Roth IRA, no doubt, but you might not be taking advantage of this mega-tax advantaged account.

No worries, you’re catching this just in time.

What is a Roth IRA:

We've discussed the IRA before, and a Roth IRA is pretty similar. It's an Individual Retirement Account you set up outside of your employer-sponsored plans and it has certain tax advantages.

So you might set one up through your financial advisor or set it up yourself through a roboadvisor, like Betterment.

The Roth IRA was named after this dude (Senator) William Roth who sponsored the idea in The Taxpayer Relief Act of 1997.

What sets it apart from the IRA is the way the contributions are treated in regards to taxes. (more on this in a bit.) But just know: IRA has pre-tax contributions, Roth IRA contributions are made after-tax, but will never be taxed again.

How does it work?

Similarly to the IRA, you can contribute up to $5,500** to your Roth IRA. 

**Note: this contribution limit applies to the total of what you contribute to both an IRA and a Roth IRA. So, if you have contributed some money to an IRA already this year than your contribution limit may be less. This is important to note as you plan and make contributions throughout the year.

**The $5,500 is also subject to how much money you (and a spouse if you're married) make in the year. If you're making over 6-figs or you're married, reference this chart to check your limitations.

What about these tax advantages?

As mentioned above, Roth IRA contributions are made after-tax, meaning, you have already paid taxes on the money you put into a Roth IRA account.

This differs from a Traditional IRA where the contributions are made with pre-tax dollars.

When it's time to retire and take your money out of a Roth IRA, however, you don't have to pay taxes on these qualified distributions. With a Traditional IRA you will have to pay taxes when you get your “retirement paycheck” from the account.

Why do you love the Roth so much?

I love the Roth because it helps eliminate your tax burden in retirement.

Some people weigh the possibility that they may be making less money when they get to retirement and will thus have to pay less in taxes, which may be true.

But if you're really going after financial freedom, like me (You know… monthly massages and frequent cocktails on the beach) you may be looking to make more in retirement.

Other folks will make projections on what the tax rate will be in the future. That's a speculation and a gamble I'm just not willing to bet my financial future on. I just can't even.

Something else to consider: If you have a 401(k) or you're making investments into a regular brokerage account (just an investment that isn't set up specifically for your retirement) then it may be nice to balance out your tax burden in retirement.

Get some of your retirement income from a taxable 401(k) deduction combined with a non-taxable Roth IRA deduction. (This is what we like to call diversification.)

Finally, there are some limitations on your ability to invest in a Roth IRA as your income grows. So now is the time to take advantage while you're still working on growing your income.

Related Articles: Listen to my interview with Sophia Bera – Retire Rich by Starting Today

Can I ever get money out of my Roth IRA?

The great thing about the Roth is that you have already paid your taxes so you can take out any money you have contributed, even before the age of 59 and 1/2, without paying taxes or additional penalty fees.

However, if your money has made any money (from invested returns and dividends) you may have to pay taxes on these earnings with an additional early withdrawal fee.

There are some exceptions, per usual, but if you can wait until you turn 59 and 1/2 then you're Free Willy to take out whatever money you choose without paying Uncle Sam a dime.

You Might Also Like: How to set up your own retirement account with Betterment in under 15 minutes.

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