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Roth IRA For Beginners! How It Works & Differs From Your 401K

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So you decided you want to start investing and keep seeing "Roth IRA" pop up in every post.

 

If you're anything like me your first question was:

What is a Roth IRA? And how is it different from a 401k?

 

In this post, I'm breaking down what this account is as well as how it works in terms that any beginner can understand!

 

What is a Roth IRA?

This is an individual retirement account that allows your money to grow tax-free. Unlike your 401k, contributions are made with post-tax money.

 

Since you’re contributing after-tax money, meaning you’ve already paid taxes, you pay no taxes when you withdraw in retirement IF:

  • You've owned your account for 5 years and;
  • You're at least age 59½.

 

Now unfortunately your contributions are not tax-deductible.

 

This means you can not deduct what you’ve contributed whenever you file your taxes like you can with a 401k or HSA.

 

Why do I need one?

Roth IRAs have no RMD (required minimum distribution) as long as you’re alive. This means that withdrawals are not required until after your death.

 

This is a nice perk because with a 401k you have to withdraw a minimum amount each year.

 

Yep, you can’t just leave your money in the account otherwise you risk a 50% tax penalty on the amounts of the RMD that were not withdrawn.

 

Basically, they don’t want this money to sit and accumulate then you try to leave it as an inheritance! 

 

An Ideal Situation:

An ideal situation is to live off your withdrawals from your 401k (since you have to make a withdrawal anyway) but leave your money in your Roth IRA!

 

And if you want to pass along wealth, you can pass the account on to your beneficiaries, and their withdrawals will be tax-free.

 

This is called an inherited IRA. Pretty smart huh?

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Roth IRA Penalty-Free Withdrawals

Right now you might be thinking:

Great, I have to wait until I'm in my 60s to use my money?!

 

And the answer is yes AND no. You can withdraw your money sooner but you could be subject to income taxes and a 10% penalty.

 

What are some penalty-free withdrawals?

If you're under 59½ and your Roth IRA has been open 5 years or more, your earnings will not be subject to taxes if you meet one of the following conditions:

  1. Purchase of your first home. Up to $10,000 in Roth IRA earnings can be withdrawn — free of both taxes and penalties — for a home purchase if you meet certain requirements.
  2. College costs. Funds can be used to cover qualified educational expenses penalty-free.
  3. Qualified birth or adoption expenses. Having children is expensive! But you can use the money in this account to help you cover birth or adoption!
  4. Unreimbursed medical expenses or health insurance if unemployed.
  5. A permanent disability or death.
  6. To fulfill an IRS levy.

 

Contribution Limits

All of this information about what a Roth IRA is sounds pretty good huh?

 

This account is so good that you can only contribute so much and contributions may be limited by how much you earn!

 

The total contributions you make each year to all of your traditional IRAs and Roth IRAs can't be more than $6,000 ($7,000 if you're age 50 or older).

 

For the year 2021, if you file head of household and make less than $125,000 then you are able to contribute up to the maximum limit of $6000.

 

Best Places to Open a Roth IRA

Looking to open a Roth IRA? Check out:

 

Conclusion

When it comes to investing, a Roth IRA can be a great choice for both beginners and those more advanced!

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