The Roth IRA: Pay Taxes Now, Skip Them Later
Okay. Last lesson we covered the IRA in general, the account you set up yourself instead of through work. This lesson we're splitting it into the two flavors, and we're starting with my favorite one.
The Roth IRA.
Here's the thing about a Roth. You put money in after you've already paid taxes on it. Not before, like a traditional IRA or your 401k. So when the money goes in, there's no tax break that year. None. It just goes in.
But then it grows. And when you pull it out in retirement, all of it, the money you put in and everything it earned over thirty or forty years, comes out with no taxes owed. Not on the growth, not on any of it, as long as you follow the withdrawal rules.
That trade is better than it sounds the first time you hear it.
Why I like this one so much for people in their 20s and 30s
You're probably in a lower tax bracket right now than you will be later. That's not guaranteed, nobody can promise you that, but it's true for most people building a career. So paying the tax now, while the rate's low, and skipping it later, when the rate might be higher, tends to work in your favor.
A traditional IRA does the opposite. You get the tax break now, and you pay taxes when you withdraw in retirement. Which flavor is better depends on your situation, and I'm a bookkeeper, not an advisor, so I won't tell you which is mathematically optimal for you specifically. That's a real question for a CPA if your situation's complicated.
But for a beginner just starting out, I'll say this plainly: the Roth gets undersold, and I think it's mostly because it doesn't come with a paycheck deduction to make it automatic like a 401k does. You have to go set it up yourself. Nobody's doing it for you. That's the only real reason people skip it, not because it's a bad deal.
The part that actually gets people started
I opened my first Roth IRA with fifty dollars. That's it. Fifty dollars, because that's what was left over after the month, and honestly I felt a little silly about it. It felt too small to matter.
Fifteen years later, that account is the one I point to when someone tells me small amounts don't count. They count. You don't have to fund the whole thing at once. You don't have to fix it all in one sitting.
How to actually do this at home
- Pick a provider. Any major brokerage will let you open a Roth IRA online. It takes maybe fifteen minutes if you have your bank account number and your Social Security number handy.
- Decide your contribution. There's an annual limit set by the IRS, and it changes almost every year, so I won't quote you a number and have it be wrong by the time you're watching this. Look up the current year's limit before you set anything up. Contribute what you can. Fifty dollars counts. It really does.
- Set up automatic transfers if you can. This is the piece that makes a 401k easy and an IRA hard, the automation isn't built in unless you build it yourself. Most providers let you schedule a monthly transfer from your checking account. Do that the same day you open the account, don't wait.
- Pick your investments. The account being a Roth doesn't invest your money for you. It just decides how it's taxed. You still have to choose what's inside it, usually a broad index fund is the simple, sensible starting point for most beginners. We're not getting into individual stock picking in this class. If you ask me which stocks to buy I'll tell you straight up I have no idea, and neither does most of the internet.
- Check the income limits. Roth IRAs have an income cutoff. If you earn above a certain amount, you can't contribute directly. This mostly won't affect beginners, but it's worth a quick check, especially if your household income is on the higher side.
One caution, plainly
Don't touch the earnings early. You can generally pull out what you contributed without a penalty, but the growth on top of that has rules about age and how long the account's been open. Pull the wrong piece out too soon and you can owe taxes and a penalty on it. If you're not sure which dollars are which, that's a question worth asking your provider directly before you withdraw anything.
The part I want to say out loud
When money got tight one winter, I cut our grocery budget without telling Aaron. I wanted to have the new number all figured out first before I brought it to him. I've since decided that was a mistake, not the cutting, the not-telling. If you're opening this account with a spouse or partner, talk about it before you've got it all figured out, not after. It goes better that way. I learned that one the hard way.
Before next time
If you don't already have a Roth IRA, see how far you get toward actually opening one before our next class, even if all you do is pick a provider. We'll compare it side by side with the traditional IRA next time, so it helps to have a real account in front of you instead of just an idea of one. 💛