I was trying to think of a fancy way to explain the concept of Roth IRAs and how all young professionals should take advantage of this investment vehicle because of their (your) low income tax bracket and couldn’t think of one – I’ll blame it on writer's block. So here it is plain and simple…
An Individual Retirement Account (IRA) is another investment vehicle to put money aside to save for your golden years. Instead of relying on your employer to sponsor this account for you, you can establish this one on your own. Not so fast… In order to invest/contribute to this type of plan you have to have “earned income”. Earned income simply means you had a job during that contributing tax year.
There are two types of IRAs - Traditional and Roth.
A traditional IRA allows you to invest pre-tax money into an account. (Think of pre-tax money as dollars never hitting your hand). You do not pay taxes on the contributions or earnings until you take a distribution from the account at age 59 ½ or after.
The Roth IRA is the complete opposite.
With a Roth IRA you invest post-tax money into an account and you do not pay taxes on the contributions or the earnings when you take qualified distributions. (Think of post-tax money as dollars hitting your hand, meaning you have already been taxed on it). Just in case you missed it, you do not pay taxes on the earnings of your investment… Why is this so sweet, especially for Gen Y? Well… right now (theoretically) you're at a low earning point in your life which translates to a low Federal income tax bracket.
Unlike a traditional IRA, defer paying taxes, with a Roth IRA you pay taxes now so when it is time to take a qualified distribution from your account it is tax free!
- Quick example: you invested $50,000 over the years and it has grown to $70,000. When you reach age 59 ½ (or after) and you want to take out the entire $70,000 you can without paying taxes. Gosh I hope you are as excited as I am.
Another sweet feature to Roth IRAs is you can, at any time, withdraw your contributions (not your earnings) at anytime without paying taxes.
- Quick example: you invested $50,000 over the years and it has grown to $70,000. You can withdraw $50,000 at anytime without paying taxes. If you touch the earnings before reaching 59 ½ OR it is not a qualified distribution, you will be subject to taxes and a 10% early withdrawal penalty.
Where to establish my new Roth IRA?
Now you are as excited as I am about (yet another) savings vehicle, where and how do you establish a Roth IRA? I found this great post that explains the different type of places you can open a Roth IRA. Check out the post here: Best Places to Open and Setup Roth IRA.
I want to make sure this message is clear…It is so important to take advantage of these investment opportunities now. I found this jargon free video that explains the benefit of contributing to a Roth IRA. This is what I call great golden financial nuggets!
Check out this video: How to Pay Taxes Like the Rich
Useful link : What the IRS has to say about IRAs