If you are wondering what is a Roth IRA, I am here to provide you the answer in a colloquial manner that, hopefully, you will understand. Let’s take a look at what is a Roth IRA.
What Does IRA stand for?
You may have heard the term IRA. In fact, you probably searched for it and ended up here. Well, let’s first dispel the acronym that everybody gets wrong: IRA.
Most people, mistakenly, think the term IRA is derived from the words Investment Retirement Account. Well, strike one my friends. Others tend to correct these people and say that the term was originated for Investment Retirement Arrangement. Strike two to you purported word-smiths.
The term actually originates from the actuary who devised the original play. His name was Ira, which is kind of geek name, no? (Actuaries are kind of geeks. I know…my dad is an actuary . Just kidding dad!)
In the end, it does not matter at all what IRA stands for. What is important is that it is a vehicle to house your retirement money and, if possible, you want to take advantage of it!
Why Were IRAs Invented
The idea of the IRA was conceived in 1974 as a way for you to save money for retirement. The original idea is that you are able to contribute money to a fund–the IRA–tax free and the money can grow tax free until you take it out when you retire at which time, ideally, it will be a hell of a lot of money as it is compounding tax free.
So, let’s say that you make $45,000 per year. If you put the maximum allowable amount into an IRA which is currently $5,000 in 2009, you decrease your taxable income by $5,000. Thus, you pay less tax and the $5,000 that you placed in the IRA is allowed to grow tax free. Pretty cool, huh.
Check this out: If you put in $5,000 for 30 years, at the end of the 30 years, your money will grow to be $150,000, right? Wrong. Assuming an annual return of 8% on that money (you always want to ensure that you get the Roth IRA best rates), you will have $611,729 in the bank at retirement when you are 60 years old. Isn’t that great? You contribute $150,000 and end up with more than $600,000. That is the beauty of compounding interest and why IRAs were invented.
So, do you ever pay taxes? Yes. When you take this money out at retirement, you will then pay taxes on the money as you take it out.
What is a Roth IRA
The type of IRA that we just discussed was the original IRA and it was just called an IRA because it was the only one. Now, however, we call it the traditional IRA because a new type of IRA has been established–the Roth IRA.
The Roth IRA was invented by a man with the last name of Roth. He was a senator of some notoriety, but in spite of being a public figure, he may have even been a good man At the very least, he invented this Roth IRA, which for most of us will be better than the traditional IRA.
Senator Roth, presumably in his later years when he devised this plan and paying a lot of taxes on his IRA withdrawals, asked the following question:
“What if we created an IRA in which we pay taxes on the money that we put in instead of on the money that we take out?”
With that simple question, the Roth IRA was born!
The main difference between the Roth IRA and the traditional IRA is when you pay the taxes. In a Roth IRA, you pay taxes on the money going in–the contribution–and not the money coming out. The traditional IRA is just the opposite–you don’t pay taxes on the contribution but you do pay taxes on the money you receive when you retire.
Not a bad idea, is it? Let’s take a look as we carry on with our analogy above. So, you have put in $5,000 dollars a year for 30 years which has accrued over that time to $611,729. In a Roth IRA, you pay taxes on the $150,000 and not the $611,729. I like that!
It seems like a foregone conclusion that people would then want learn how to open a Roth IRA quickly and get started. No?
There is one thing that we have to remember. With the traditional IRA, we saved money each year by not paying taxes on the money we put into the IRA. If we assume an 8% growth on this savings, we get a figure of more than $100,000 dollars.
So then, which is better?
For most people, the Roth IRA will provide a better return in the long run, though it will not be a monstrous difference. But, the Roth IRA does have some other advantages as well.
Some other Roth IRA Advantages
1. In many situations, since you have already paid taxes on the principle, you are not penalized for early withdrawals.
2. You do not have to take the money out of your Roth at a certain age as you do with a traditional.
3. Roth IRAs are more easily passed through as inheritance.
For insanely detailed details, check this Wiki page.
More Roth IRA Questions
How Much Can I Put in My Roth IRA: Find out more details on how much you are able to put in your Roth IRA and alternatives that may be available to you.
What Is a Roth IRA: Summary
I have endeavored to make clear the primary differences between a traditional IRA and Roth IRA. I may have succeeded. Did I? Can you now answer the question, “What is a Roth IRA?”. If so, I did my job. If not, comment below and let me have it.
Basically, it’s a matter of when you pay the taxes. With Roth, it’s when it goes in. With traditional, it’s when it comes out.
A Roth IRA usually makes more sense but the difference will not be as huge as it may originally appear!