If you're earning taxable income, like through a job at Starbucks, an IRA is a great place to begin investing. There are a couple different types of IRA’s and in this article, I'll be going over the terms and advantages of a Roth IRA.
The main advantage to IRA’s is the fact that they are tax-advantaged. This means that they follow a different set of rules when it comes to taxes.
With a Roth IRA, you deposit post-tax income, meaning you’ve already paid taxes on the money you’re using. You can use this money to invest in a variety of assets, just like any other brokerage account. You can purchase stocks, bonds, ETFs, and index funds.
Then, unlike other brokerage accounts, when you decide you need to withdraw money from the Roth IRA, all your profits are tax-free.
In a normal brokerage account, you’d have to pay long-term capital gains on any realized profits (realized simply means you’ve actually sold the asset and closed the position). Long-term capital gains can reach up to 20% (varying based on income and filing status), meaning if you made $100,000 holding, say Apple stock, you’d only be able to take home $80,000. In a Roth IRA, you’d get to keep all $100k.
Because Roth IRA’s are funded using post-tax income, they are great for a few different demographics, the first being low-income workers. If you're earning a low income, or expect to earn significantly more in the future, a Roth IRA is beneficial for you because you get to contribute at a lower tax rate early on, and if in retirement your income increases, and therefore your tax rate, the increased tax rate won't affect your Roth IRA profits.
The opposite applies to a Traditional IRA, which I’ll talk about in the next article.
Additionally, if you expect tax rates to increase by the time you're in retirement, a Roth IRA is great for you, as the new tax rates will be irrelevant to you because withdrawals are tax-free. So, even if taxes are much higher, you still get to keep 100% of your profits.
A Roth IRA does come with a few limitations. The first is an income limit. If you make over $140,000 and are single or over $208,000 and are married, you're officially too rich to contribute to the Roth IRA. However, there is a way to circumnavigate this limit using a backdoor Roth, a concept I can discuss later on if any of my readers are making this much money (if you are, my PayPal is currently accepting contributions).
Additionally, you can contribute up to $6,000 every year into a Roth IRA, or up to $7,000 if you're over 50.
You’re also only able to withdraw profit from the Roth IRA once you're 59½ years old (it's important to note you can withdraw deposits/contributions at any time, only profit is restricted). If you withdraw before this age, you'll have to pay a penalty of 10% and/or taxes on the profit.
The main exceptions to this age restriction are if you use the profit to build your first house (up to $10k) or if you have a permanent disability.
In short, a Roth IRA is a great vessel you can use to save for retirement. If you meet the requirements, you’re able to use post-tax income to invest, allowing profits to be completely tax-free. It's great for younger people or those who expect their income to increase later on in life. Start saving now and enjoy tax-free returns in the future.