Alternate title: The Magic of Tax-Free Compound Interest
(disclaimer: this was written in April 2024, there may have been updates to tax code since then. also, this is not professional tax or financial advice, everyone’s situations are different, and for personalized financial advice please prefer to a professional!)
I discovered the concept of Roth IRAs during college, and was immediately obsessed. Personal finance can be as complicated as you want to make it – some people spend hours reading tax codes and hyper-optimizing every decision. Most people don’t have the time to do that, but using a Roth IRA to save for retirement is a simple way to save massively on future earnings. You can start contributing as soon as you have earned income. There’s no time to start like now!
What is a Roth IRA?
Let’s take a step back – an Individual Retirement Account (IRA) is a type of account. You can open this account at most banks and brokerages. This account is specifically designated for retirement savings, so it comes with tax incentives towards that purpose.
Important note here – a Roth IRA is not an actual investment, like buying stocks or a house. You should think of it a bucket for your money. Once you put money in that bucket, it is subject to the tax rules applied to Roth IRAs & you can invest it in stocks, bonds, or other investments! Different rules apply to your contributions (the money you invest) and your gains in the account (the money that you make from your investments in the IRA).
There are two kinds of IRAs – Roth and Traditional. They differ in their tax treatments. In a normal brokerage account where you buy stocks, you (1) pay income taxes on the money that you invest and (2) pay taxes on the gains / income from your investments growing. Your tax rate depends on your tax bracket, but this can be a huge chunk of your savings! The Roth and the Traditional accounts offer advantages in these two areas.
In a Roth IRA, you contribute post-tax money. This is earned income on which you have already paid taxes. You can withdraw contributions from your Roth IRA at any time without a penalty. At 59.5 years old (as long as the account has been open for 5 years), you can withdraw contributions and gains completely tax-free! You will not pay any taxes on the money that your initial contributions have earned!
In a Traditional IRA, you contribute pre-tax money. You do not pay taxes on the money that you contribute to this account, so you will claim a deduction when you file taxes. This means you get to invest a larger principal, which will accrue larger gains! Then, at 59.5 years when you start withdrawing money, you will owe taxes at your current tax rate (at 59.5 years old) on the amount you withdraw.
Why Roth?
If you are in the exact same tax bracket now vs. at 59.5 years old, the Roth and the Traditional IRAs get you to the same place. If you think you’ll be in a higher tax bracket at 59.5, you are better off paying taxes now – and vice versa.
It’s hard to know where you will be in life at 59.5, so some people recommend having a mix of Roth and Traditional retirement accounts. If you work a traditional job, your employer probably offers a Traditional 401(k) plan with an employer match (hopefully!). Opening your own Roth IRA gives you a chance to diversify the tax treatment of your retirement savings.
The Roth IRA is great for college students who are earning money at on-campus jobs or summer internships and have extra money to save up – since you are making very little money (probably) because you’re working part-time, you are likely in a very low tax bracket. That means you can pay almost no taxes on the money that you contribute to your Roth, which would then grow tax-free!
How do I get started?
There are a few steps that we can outline here:
- Open a Roth IRA account at a brokerage
- Deposit money in the account (not more than the annual limit!)
- Invest your money
and you’re done!
OK – I opened an account. Am I done?
NO!!!!! Go back to the previous section! You have successfully opened an account and deposited money into it, but this is not the end. The point of a Roth IRA is that your money grows tax-free – and how is your money going to grow if you don’t invest it?
You need to pick something to invest your money into. This is a whole other topic, and there is lots of great reading on the Internet for this question!