Everything You Need to Know About a Roth IRA

This post was inspired by a great movement that has been started and organized by one of the Yakezie bloggers, Jeff Rose. He blogs at Good Financial Cents and you can read more about the movement here

As it stands there are over 130 financial bloggers that are all writing about Roth IRAs and why we love them. We’ve all agreed to launch our posts, today, March 27th and discuss why they’re so important.


If you want to follow along on Twitter, check it out at #RothIRAMovement.

The driving factors that caused me to take part in this movement is two-fold:

1. It’s important for each person to save for retirement and the Roth IRA is a great vehicle to do that.

2. I have yet to talk about investing and retirement savings on this blog, so this opens up a great opportunity for me to start my 6-week series about investing and retirement planning!

What is a Roth IRA?

  • A Roth IRA is a self-directed retirement account.IRA stands for Individual Retirement Account. This simply means that it’s not something that is done through your employer; it’s something that you open, fund, and manage on your own (or through an advisor).A Roth IRA IS NOT an investment (like a stock, bond, etc), it is simply a vehicle that allows money to grow tax-deferred. You can choose investments within the account but I’ll get to that another day.
  • A Roth IRA is funded with AFTER-TAX dollars.Your contributions to a Roth IRA are made with money that you’ve already paid taxes on.I find some people get confused at this point, but I’d encourage you not to over-think it: your wages/paycheck got taxed prior to your money being deposited into your bank account. And you use that money (your take-home pay) to fund the Roth IRA.
  • Downside: You have to find room in your budget to make contributions.The reality of the average American’s financial situation is that we get paid, cover all of the bills for the month, and spend the remainder.We don’t “have room” in the budget to put money into an emergency fund account, let alone find $25-$400/month to put into retirement savings!

    So that’s why MANY Americans opt to contribute to a 401(k) instead of a Roth IRA. The 401(k) contributions come out before you ever see the money, so you’re not tempted to spend it.

    If there is any downside to the Roth IRA, it would be found in your lack of discipline or inability to live well below what you make.

Why I Heart the Roth IRA & Why You Should Too!

If you get confused with the terms 401(k), 403(b), 457, Traditional IRA, Roth IRA, SEP, SIMPLE, or TSP, then I’d encourage you to bare with me and check back next week as I’ll help you understand that better.

For now however, we’re going to focus on the Roth and why it’s SIMPLY AMAZING!.

There are four really important things that make this particular retirement account VERY special:

  • 1. You NEVER pay taxes on your earnings!You fund your Roth IRA with after-tax dollars, however EVERYTHING you earn (all of the interest you accumulate over the course of time) grows TAX-DEFERRED and you can withdraw it after age 59 1/2 TAX-FREE!Tax-deferred simply means that your interest grows without you having to pay taxes on it each year. For instance, you may get a 1099-INT form if you make enough interest in bank accounts, on CDs, or in a normal brokerage account. However, all qualified retirement accounts don’t get taxed until you withdraw the money (except the Roth IRA of course).

    This isn’t some gimmick or a crazy scheme to out-smart the IRS. They’re well aware of this benefit and that’s why there are restrictions to it (keep reading).

    There are only 3 investments that I’m aware of that offer this unique, TAX-FREE benefit:

    1. Municipal bonds

    2. Cash Value in Life Insurance if properly withdrawn

    3. Roth IRAs!

    The “Muni” bonds and Cash Value life insurance have hurdles, low rates of return, and do not offer anything near what a Roth IRA does, so imagine I never mentioned those.

    Let’s take a look at a hypothetical situation to better grasp this whole TAX-FREE concept:

    Sally Sue opens up a Roth IRA and contributes $5,000/year to it for the next 20 years. Assuming an 8% average rate of return over that 20 years, Sally would have $247,114 in her Roth IRA.

    WOOHOO! That’s pretty impressive considering she only put in $100,000 of her own money!

    Now, let’s also say Bob (Sally Sue’s husband) contributes $5,000/year to a Traditional IRA (or 401(k), 403(b), or 457) for the same 20 year period. Assuming the same 8% average return, it just so happens that Bob will have $247,114 in his account too!

    So, what’s the big deal?

    Well, the big deal is that all of Sally’s earnings from her Roth IRA are FREE FROM TAXES!! That’s $147,114 that she made in interest that she gets to keep all to herself!

    Poor old Bob on the other hand still has NEVER paid taxes on his contributions or his earnings. That leaves him knowing that ALL of the money in his Traditional IRA (or 401()k, 403(b), 457) is 100% TAXABLE.

    Assuming Bob is in a 15% tax bracket in retirement, that means he really only has $210,047 and the remaining $37,067 is the government’s. Uncle Sam just did the Snoopy dance.

Roth vs IRA

Assuming (for whatever ridiculous reason) that example isn’t enough to convince you that you NEED to contribute to a Roth IRA, here are a few others:

  • 2. You KNOW what your tax liability is going to be.

If you’re paying taxes TODAY on your Roth IRA contributions, then you know what they are.

The downside to the Traditional IRA, 401(k), 403(b), and 457 is that we have absolutely no idea what taxes will be 20 years from today.

I assumed 15% in Bob’s example above, but frankly I DON’T think that will be the case. The reality of our country’s dire financial situation suggest that taxes are going to go up.

If you want to gamble and hope taxes are still low 20 years from now, then that’s your call.

  • 3. There are NO Required Minimum Distributions (RMDs)Few people know this unless they’re in retirement, but a Traditional IRA, 401(k), 403(b), and 457 have something called Required Minimum Distributions.Basically, at age 70 1/2 the government is going to REQUIRE that you start to take money out of those retirement accounts whether you want to or not.

    The reason for this is simply that they’re tired of waiting on their tax money. Remember, you don’t pay taxes on all of that money until you take it out.

    On the other hand, you’ve ALREADY paid taxes on your Roth IRA contributions (and you don’t pay taxes on your earnings), so the government could care less when you take the money out.

  • 4. Your Roth IRA can Go to Your Beneficiaries TAX-FREE!There are a few minor qualifications here (like having your Roth IRA open for at least 5 years), so always seek a tax specialist or estate planning attorney for your specific situation.However, in most scenarios, your Roth IRA will go to your beneficiaries completely tax free!

    The primary circumstance where this wouldn’t be the case is if you fall into the dreaded ESTATE TAX. Meaning, if your total estate is worth more than $5,120,000 (2012 limit) at the time of your death, then the estate tax applies to everything (including a Roth IRA).

So, What’s the Down Side?

If something sounds too good to be true, then it generally is. While that isn’t completely the case for a Roth IRA, there are some things that don’t make this the GREATEST thing since HD TV’s and smart phones.

  • 1. Income RestrictionsFirst-and-foremost you have to have earned income to be able to contribute to a Roth IRA. This ISN’T the case for spouses as you can open up a Spousal Roth IRA if one of you isn’t employed or is a stay-at-home mom/dad.Where this does come into play is for children and retirees. In order for you to open up a Roth IRA for your child, they must have qualified earned-income and you cannot contribute more than they earned (up to $5,000).

    Also, true to our American ways of loving to punish people that make too much money, the big part to Roth IRA income restrictions is that you can only contribute to one if you:

    a) Have a Modified Adjusted Gross Income of less than $173,000 (2012 limits) Married Filing Jointly. There is actually a phase-out starting at $173k and ends at $183k.

    b) Have a Modified Adjusted Gross Income of less than $110,000 (2012 limits) filing as a Single or Head of Household. Phase-out starts at $110k and ends at $125k.

  • 2. Contribution LimitsOf course the government doesn’t want to give anybody too much of a good thing, so they make sure to limit how much you’re allowed to contribute to a Roth IRA.If you’re under age 50, then you can contribute up to $5,000/year per person. So, if you’re married, that means you can do $10,000 combined.

    If you’re over the age of 50 then there is a $1,000 catch-up provision, which means you can contribute up to $6,000/year per person.

  • 3. A Roth IRA is a retirement account.You’re not allowed to take money out of your retirement account until you’re 59 1/2. If you choose to do so, you’re going to get slapped with a 10% penalty ON TOP OF paying taxes on the earnings (so the Roth IRA doesn’t grow tax-free if you take it out early).There are special situations (i.e. down payment on your first home, avoiding foreclosure, etc) where you can take money our of “retirement” accounts before age 59 1/2, but please seek a competent professional or check the IRS tax rules for all qualifications.

    The bottom line is that the Roth IRA should be viewed as a retirement account. Don’t touch the money…act like you don’t even have it!

So, Why Should You Start a Roth IRA NOW?

As a financial advisor, as a person that understands the long-term effects of inflation, and also realizing that the end of Social Security draws nearer by the day, it has NEVER been more important for you to start contributing to your retirement AS SOON AS POSSIBLE.

Did I state that clearly enough? Let me try it again.

Regardless of your age and if you’re making money

I’ve coached, advised, and talked to hundreds of people that are in their 40s, 50, and 60s, and I’d say that 90% of them wished they would have started contributing earlier to retirement savings AND would have contributed larger amounts of money.

The problem we face today is that many of us fall into the trap of living only for the here-and-now. However, the reality is that tomorrow will come…retirement WILL come

The question is will you be ready and will you have saved enough to be able to enjoy it?

Keep coming back as I’ll continue to walk through retirement planning and investing over the next couple of weeks. Here is what you can expect:

Picture by 401K.

About the Author

By , on Mar 27, 2012
Andy Tenton
Andy is a 30-something New Yorker who turned his financial life around. He took charge of his finances, got out of debt, and is now working his way toward financial success. He is the publisher of WorkSaveLive.com.

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  1. NuView IRA says:

    Great article – I loved the numbers breakdown! The nice thing about a Roth IRA is that you will not have to face RMDs later, unlike with traditional IRAs. Once you reach the age of retirement, not having to worry about paying tax on withdrawals can make your life much less stressful. Also, anything left to your heirs goes to them tax-free, rather than being taxed in their top bracket.

  2. Great detailed post. I think the easiest way for me is to set up automatic contributions. I already do that with savings and with my employer retirement, but my Roth IRA hasn’t had any contributions in 2012. Every month I work harder at having “money left over” for savings and retirement. It’s been slow but I know things are changing and there will be a breakthrough month where I finally come out way ahead with things coming together (no frivolous spending, working hard with OT and side income, budgeting on the groceries). It has been extremely encouraging to see my debt go down each month, now I just need to focus on increasing balances on the other side of the ledger too :0)

  3. Hi Andy,
    Thank you for explaining this very clearly. It’s really very helpful for those of us who get easily confused by unfamiliar terms and complicated processes. For me, posts like this make financial education interesting.
    I’m kind of late to the game of saving and investing for retirement and I would like to make up for lost time. This time I am paying attention especially to your advice to start as soon as possible regardless of age which I can pass on to my kids.
    Thanks for sharing this very informative article!

    • Andy says:

      I’m glad this helped Theresa! This is a very confusing topic for a lot of people…the whole retirement planning process is but the alphabet soup that people get thrown at them (IRA, Roth, SEP, 403b, etc) makes it even worse.

  4. Shilpan says:

    Andy, I think anyone who is unemployed shall consider moving money from regular IRA to Roth IRA. I may be wrong but if you have no other income than unemployment benefit, you are in lower tax bracket. That’s the best time to convert a simple IRA to Roth.

    • Andy says:

      Absolutely great point! A conversion from an IRA to a Roth IRA should always be considered, and even more-so when you’re in a lower tax bracket (for whatever reason)!

  5. Katie says:

    I don’t have a 401k at work and I have not yet opened a Roth IRA. I was planning on opening one soon. I think this post just answered all the questions I had about Roth’s, Thanks Andy!

    • Andy says:

      I’m glad it could help! I will have the Retirement Investing Order of Priority here in a few weeks and if you can’t do a 401(k) then the Roth IRA is certainly the next place I’d look to stash the cash!

  6. Great info! What is missing from this article is what to do now. I’m 30, I contribute to a traditional IRA. This will be the first year I max out my contribution. So what? Do I roll all of that over to a Roth? Do I open a new Roth? Can I have both? Your advice is great and saving for retirement is necessary, of course, but all the posts I read yesterday were more geared toward people who don’t yet have any retirement.

    PS found you from Yakezie and you’re not just plain under 200K to me, you’re at 180! Great work!

    • Andy says:

      These are all great questions FP and I’m sorry I didn’t answer them. I thought the post was already too long and you just can’t fit everything in. 🙂

      To answer your questions though:
      1) You can keep your Traditional IRA as it is and not contribute further to it (instead to a Roth). Just let the money keep growing tax-deferred and solid investments.
      2) The other option is you can CONVERT your Traditional IRA to a Roth IRA (any amount you choose or all of it). The thing with that is you WILL pay taxes on all of the money you convert when you file taxes for this year (or whichever year you decide to CONVERT). The benefit here is that you know what taxes are today, but the downside if you obviously NEED to come out of pocket to cover those taxes (you can technically use money from the IRA to pay those taxes, but I personally wouldn’t do that as it nullifies the benefit of the conversion then).
      3) I would personally open up a Roth IRA and start making contributions to that and forgo the Traditional IRA. The $5,000/year/person contribution limit is for ALL IRAs. So, you can put $5k into a Traditional OR into a Roth. Or you can do a combination of the two UP TO $5,000 (so $2500 into a Traditional and $2500 into a Roth).

      Hope that helps!!

  7. Karunesh says:

    By end of this movement I would become an expert on Roth IRA in my town 🙂
    Thanks for sharing 🙂

  8. I am really impressed with the Roth IRA Movement. I’ve seen it in a bunch of places today.

  9. Riley Rothe says:

    I have the benefit of having an employer who offers a Roth 401(k) in addition to a traditional 401(k) to get the best of both worlds, a contribution growing tax free and automatic deductions from my paycheck. I would encourage people to look for their company’s information on http://www.brightscope.com/ to evaluate how their plan compares to other similar organization. They have a responsibility to pressure their company to improve the plan for the employees. They have helpful hints on how to make that happen.

    • Andy says:

      It is such a HUGE benefit to have a Roth 401(k). I’m jealous!

      Thanks for sharing that website – that’s pretty awesome they do that. I’ll have to check that out tomorrow!

  10. Bryan says:

    I’m loving all these articles about the Roth! It’s a great investment option, and I believe the day has done a lot to promote just how useful it is.

    • Andy says:

      I agree – it has been a lot of fun to see how many bloggers took part in this movement. Some of the posts have been really helpful and a few of the bloggers got really creative with their posts (i.e. Money Infant).

  11. Love the numbers comparison between a Roth IRA and a traditional IRA! The pros of a Roth IRA definitely outweigh the cons.

    • Andy says:

      I hope everybody begins to understand that! It’s such a nice thing to educate people and give them some guidance. Knowledge (applied) is power!

  12. Wow! This is the most thorough and comprehensive article I’ve read in the movement today so far! I don’t have a 401(k) since I’m self-employed, so I can’t WAIT to open mine.

  13. CultOfMoney says:

    Actualy one of the cons to your Roth IRA has disappeared recently, that being the income cap. You can get around this by contributing to a traditional IRA deductible or non-deductible) and then converting it into a Roth. Even better.

    • Andy says:

      This is true but I didn’t really want to go into conversions and “semi” loop-holes (my post was already getting wayyyyy to long).

      The non-deductible IRA to Roth conversion only works well if the person DOES NOT have pre-existing Traditional IRAs. If they do, it’s definitely not as great of a “work around.”

      Other than that, it is an absolutely fantabulous way to get around the income limits.

      • CultOfMoney says:

        That’s true if you have comingled accounts, life is much easier for conversion if you create a separate account each tax year. I thought your post was great though. Longer posts are nice to read from time to time.

  14. Beautiful post! The Roth IRA has to be the greatest savings vehicle ever invented. Anyone who doesn’t know what is it by now is either not paying attention, or just doesn’t understand its features and benefits. You’ve done a fabulous job introducing it and breaking it down to its most basic terms for the layman to understand. I agree with you that everyone, regardless of age, needs to start one immediately. Thanks for this post.

    • Andy says:

      Thanks for the kind words, Anthony! It is unfortunate that a lot of people don’t know the benefits of a Roth IRA, but that’s what this movement is all about!


  15. AverageJoe says:

    You scoundrel! You worked in RMDs into your discussion….I opted to “not go there” in my post, but you nailed the landing. Even the crazy judge on the end was crying as she gave you a “10.”

    • Andy says:

      I nailed the dismount and the landing! Boom!

      I love the RMD discussion…it’s a big deal for people that have built a large amount of assets and for people that plan to work past age 70.

  16. Bichon Frise says:

    I like that you beat on the drum of a Roth IRA being a retirement account. Advising for less trickeration and using the tool for which it was designed is always a good thing in our book!

    One thing, your analysis between Sally & Bob isn’t quite fair. Sally’s contribution needs to be reduced by the taxes paid or Bob’s needs to be increased by the taxes he isn’t paying. We did a whole post on this…http://wp.me/p2h40p-1c

    • Andy says:

      You’re absolutely correct, Bichon, and it’s a great point.

      A big part of the Roth IRA is making a sacrifice TODAY: more money comes out of your pocket (as opposed to a Traditional IRA) to cover the taxes. So for Sally to contribute $5,000 she really had to use $6,250 of pre-tax money. Whereas Bob only had to use $5,000 of pre-tax money.

      The reality is that you can either sacrifice today (with a known tax rate) or you can sacrifice later (with an unknown tax rate). Regardless, I didn’t feel the need to show this sacrifice as they’re both contributing the $5,000 limit – one just happens to be a Roth and one happens to be a Traditional.

      • Nice work! This is a very comprehensive description!

        Although Bichon is right about the now or later tax situation, I would like to add something to Andy’s point that benefits the Roth further:

        With a Traditional IRA if you invest the full $5,000, then we know that taxes apply in the future (let’s say 25%), and that means you’re really only stashing away $3,750 after taxes (math: $5,000 x (1 – 0.25)).

        With a Roth IRA when you invest the full $5,000, the taxes apply right now (again let’s say 25%). That means you can really start off with $6,667 to put away (math: $5,000 / (1 – 0.25)) and lose $1,667 to taxes. But the full $5,000 makes it to the fund!

        This “effective rate” is a very important mathematical distinction between the two types of funds ($6,667 vs $5,000 in our 25% tax example)! It allows you to bank more money for future growth potential!

        I have an example worked out if anyone would like to review the numbers:


        I have been a long time investor using a Roth IRA. By the way – you are allowed to withdraw the principal amount of your investment after five years if you need without tax penalty. I highly don’t advise ever withdrawing the money because it would mean less potential for investment (or compound interest effects). However, it is nice to know you have the option in case there ever was a disaster and your emergency fund is not up to snuff.

        • Andy says:

          I really like your detailed review of the numbers on your blog posts. I love facts as there is no disputing them.

          Also, I didn’t mention the ability to withdrawal contributions for the mere fact that I don’t want people to think that way. This flexibility is a nice thing but this way of thinking is also a BIG reason as to why 40% of the people over age 55 have less than $25,000 saved for retirement.

  17. Tawni says:

    Great info, Andy! I’ve been chomping at the bit to invest in Roth IRAs for myself and my husband. We’ve been on Dave Ramsey’s Baby Step 2 for a few years and will actually have our debt paid off this July if all goes well! My husband is 32, and I am 30 years old. The only retirement we have is a 401k that his company matches (a measly 2%), but we were planning on waiting until, as Dave recommends, our 6-mo emergency fund is in place before we start Roth IRAs. Our emergency fund may take another 8-12 months after July to build up. Do you think it’s unwise for us to wait that long to start our Roth IRAs? Any advice is welcomed!

    Thank you 🙂

    • Andy says:

      Thanks for the wonderful question, Tawni!

      Debt free by July…WOOOHOOOO! Good for you! I feel your pain about being on Baby Step #2 for awhile, but it has to be really exciting to see the DEBT FREE day rapidly approaching!

      In regards to the retirement savings:
      1) It’s wonderful that you’re taking advantage of this now! Also, I wouldn’t scoff at the 2% match. Any FREE money is a wonderful benefit. Sure, there are some matches out there that are higher, but many companies have cut back significantly on this benefit post-2008.

      2) I don’t think there is a “right” answer to your question – it’s more about preference and comfortability. If you want to be ultra-conservative and follow Dave Ramsey’s steps to the tee, then I don’t think there is anything wrong with that. Delaying additional retirement savings for 1-1.5 more years isn’t the end of the world (especially considering your age).

      However, if it were me, I’d probably build my E-Fund up to 2 months worth of expenses and then split my disposable income into two parts: (1) 1/2 to the Roths and (2) 1/2 to build the remainder of the 6-month Emergency Fund.

      Technically, my way is a little riskier (slightly) but it would allow you to have an additional year that compound interest works for you.

      At the end of the day I think it really just comes down to what you’re comfortable with. There is something to be said for focused effort and getting a goal knocked out, and there is the argument that having the extra TIME for compound interest to work is a big deal.

      Hope that helps!

      • Tawni says:

        The 1/2 and 1/2 plan sounds like a really great idea! Building 2 months emergency fund would allow us some breathing room, but I like the idea of having the extra year of compound interest. We both have jobs, so in an emergency, it wouldn’t be as grave a situation if we only had the 2 months stashed right away.

        • Andy says:

          Glad I could help Tawni! Also, in an absolute worst-case scenario you could take money from the Roth IRA (with penalty) if a serious emergency happened before you could build up the fully-funded emergency fund.

          I believe that’s an unlikely scenario but it’s nice to know that it’s there if you absolutely had to have it.

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