A Roth IRA is another retirement vehicle, but it is funded differently. Whereas the 401k is pretax and taxed later during the withdrawal phase, the Roth IRA is post-taxed. This means you are unable to use it for tax purposes.
Why is it enticing?
Once you pay the taxes on it, you don’t have to pay taxes on it again. This is very helpful to someone who is currently in a low tax bracket and believes they will be in a higher tax bracket during their retirement age. For example, if you have an 18-year-old investor and they are at lowest possible tax bracket, they would be wise to invest into a Roth. Keep in mind that if they were to invest $200 per month for a period of 15 years at a return rate of 8% in a Roth, they would have $75,452.00 in tax-free money and 33 years of age. If they were retiring at the age of 67, without ever putting in another dime, they would have $1,032,510.00 of tax-free money using the previous 8% return on investment.
There are a few rules that must be considered when investing into a Roth that make it different from other retirement accounts.
- Contributions can be withdrawn tax free and without a penalty. There is no penalty with this, but you can only withdraw from your contributions, not from your returns.
- Your may also withdraw for a qualified purchase of a new home.
- There are income limits that change yearly. You will need to see if you fall into this category before you begin investing.
The Roth certainly makes sense if you believe you are currently in a lower tax bracket and plan to be in a higher bracket during your retirement. It can also be used in conjunction with a 401k plan using the strategies that we discussed in Should I invest the max in my 401k?