These days, it feels like there is an insurmountable pile of personal finance tasks we all "must" do, from starting an emergency fund to defining our long-term savings goals. Sometimes it's difficult to parse out what is really necessary and what is optional. And, when it comes to retirement accounts, there's the added anxiety when thinking about how the hell to save for your future.
It's likely you've heard of about Roth IRAs and have some sense that you should probably get one, but, if we're being honest, it can be hard to know where and how to start. For those of us with employer-sponsored retirement plans (whether that's a 401(k) or a 403(b)), it can be tempting to ignore other long-term investment opportunities. But there are many reasons why Roth IRAs are something you should consider — regardless of what your employer offers.
Refinery29 chatted with Manisha Thakor, CFA, CFP, and VP of Financial Wellbeing at Brighton Jones (and one of the experts in our Money Diaries book!), to demystify this particular type of retirement savings and shed some much-needed light on how exactly they work and why you want to make sure you get one.
So, what exactly is a Roth IRA?
“A Roth IRA is a type of ‘tax-advantaged retirement account’ that anyone with ‘earned income’ can open up at the financial institution of their choice and contribute to annually.
“You can have a Roth IRA even if you have a retirement plan at work — such as a 401(k), 403(b), 457, or thrift savings plan, which depends on whether you work for a for-profit corporation, a non-profit, or the U.S. government.
“The caveat with Roth IRAs is that you can only contribute to them so long as your income doesn’t exceed certain limits. This limit differs if you're single or you're married and filing your taxes jointly. These income limits can change from year to year. The easiest way to find out how much you can contribute this year is to visit the IRS website."
Why should I get one?
“Generally, when it comes to retirement, getting in the habit of setting aside money every single month for retirement is the best way to ensure you don’t end up old and poor.
“Roth IRAs enable you to save for retirement in two different situations: (1) If you hit the maximum limit that the government allows you to contribute to your employer-based retirement plan (such as a 401k) and you still have extra money available to save for retirement or (2) your employer doesn’t offer a retirement plan.”
When should I open a Roth IRA?
“In an ideal world, you should open one as soon as IRS rules allow you to! The government allows you to open a Roth IRA as soon as you have ‘earned income.’ This definition has a bunch of nuances (which you can read about here), but, broadly speaking, it means any money you earn from working a job that you report on your tax return.
“I recommend opening a Roth IRA the minute you start earning taxable income (so this could happen as early as high school or college if you have a part-time job). At this young age, you have the most time to let your investments grow for you through compound interest.
“Another reason to open a Roth IRA is if you don’t have a retirement plan at work, since a Roth IRA enables you to save for your retirement in a ‘tax-advantaged’ way.
“Yet another reason to open a Roth IRA is if you are married, file your taxes jointly, and are not earning income (for example you are staying at home raising kids). Wait! Didn’t I just say you have to have “earned income to contribute to a Roth IRA? Yes — but there is one exception to this. For couples who file their taxes using the tax status of ‘married, jointly,’ the non-working spouse can contribute up to the maximum limit so long as the total household has income at least as much as that contribution. This is called a ‘spousal Roth IRA.’”
How much should I contribute?
“You should contribute as close to the annual maximum allowed as possible, once you have already stashed away a $2,000 starter emergency fund."
“Additionally, if you have credit card debt, student loan debt, or any other type of debt with an interest rate of 6% or more, you want to make the minimum payment on that debt plus add a minimum of an extra $50 a month above and beyond that minimum payment (to speed up the rate at which that debt is paid off) and then only after that, with money that’s left over, start contributing to your retirement accounts.
“The reasons you should prioritize paying down your debt is that there is no guarantee of what kind of return you will receive when you invest. But for every dollar of debt you pay off, you are in effect earning a ‘return’ of whatever the interest rate on that debt is because you do not have to pay out that amount in interest.”
When is a Roth better than a 401(k)?
“A Roth IRA can be better than a 401(k) if the 401(k) investment options offered by your employer are expensive.
”You can find out the ‘cost’ of the investment options by asking what the ‘expense ratio’ is for each investment option. These expenses are taken out of your ‘return’ (a.k.a. the money you make on your investments) so you don’t see them directly, but they are a really big deal. Each incremental 1% you pay in fees over a 30-year period of investing (assuming historical average after-inflation returns in the stock market) could mean you have 20% less money when you reach retirement.
“Roth IRAs are also a good idea if you have contributed the maximum to your employer’s plan, and you still want to save more money for retirement. To find out the annual maximum that you can contribute to your workplace retirement plan in any given year you can Google: ‘401(k) contributions limits for 20XX.’ You must specify the year since limits increase periodically to keep up with inflation.”
How do the taxes work?
”Now we get to the beauty of a Roth IRA (and why people make such a big deal about them). Since you contribute ‘after-tax’ dollars to a Roth IRA, you’ve already paid taxes on that money. This means that when you get to retirement, you can spend every single dollar that is in that account.
“By contrast, in non-Roth accounts, when you pull money out in retirement you have to pay taxes on it.
“So let’s assume Jane has $500,000 at retirement in her Roth IRA. She gets to spend that whole $500,000 because she pays no taxes on withdrawals from a Roth IRA.
“On the other hand let’s assume her friend Kate has $500,000 in a Traditional IRA at retirement. Because Kate didn't pay taxes up front, when she takes out money from her Traditional IRA she has to pay taxes on it at her current income tax rate.
“This means she doesn’t have $500,000. To use a very simplistic example — assuming Jasmine’s effective tax rate is 20% — she will only have $400,000 of that $500,000 in her IRA to spend. The other $100,000 will have to go to the government.”
How should I invest my money?
”Hands down, unless you love studying investing and are willing to become a deeply informed student of the craft (or you have enough in assets to hire a wealth manager — but alas most of those require you have a minimum of $250,000 or more to invest), you should invest your money in a ‘target date retirement fund.’
“Target date retirement funds are like the financial equivalent of an all-in-one shampoo and conditioner. In this one investment, you own lots of different stocks and lots of different bonds — I’m talking thousands — so you are very diversified.
“These mixes can be created in two different styles: ‘active’ and ‘index.’ Active funds are much more expensive than index funds. So you want a target date retirement fund composed of index funds.
“When you are young, your target date fund will be composed of a higher percentage of stocks because you can afford to take more risk. As you get older, the funds gradually shift from stocks to bonds, which are more conservative investments and more appropriate as you approach retirement.
“In short, this is a one-stop investment that you can keep putting money into year after year. The funds have names that end in years. Like ‘target date 2040’ or ‘target date 2045.’ The years are in increments of five and you want to choose the one that is closest to the year when you will turn 70.