How does a Roth IRA work and why is it important?
A Roth IRA is a tax advantaged brokerage account. Normally when you have a brokerage account, any gains you make on assets you buy within the account are taxable so for example if I buy 1 share of X corp at $100 in my normal brokerage account and the value of that share goes up to $120 if I sell the share I owe taxes on the $20 gain I made. In a Roth IRA I don’t owe any taxes on that gain provided that I withdraw/sell after I’m 60 and also with the added caveat that I can only contribute a certain amount of money to the account per year( right now you can contribute a max of $6500 for the 2023 tax year), this maximum also decreases the more income you make and after a certain income threshold you are not allowed to contribute at all. As for the reason why having a Roth IRA is important is largely due to having tax free gains. If you dutifully start contributing and maxing out your account from the time you are young till retirement age in your 60s those gains can be a ton of money which you have as a tax free nest egg to enjoy for your retirement
In the United States, people are taxed on their wages as well as their investment income and returns (this includes interest, dividends, and increases in the price of stocks). To encourage folks to save more for retirement, the government created two types of retirement accounts with tax advantages.
The first, Individual Retirement Accounts (IRAs) are pre-tax. What this means is that the money you deposit does not get taxed as wages / income. If you make $50,000 per year and deposit $5,000, as far as the IRS is concerned, you only made $45,000. At a 20% tax rate, you owe the IRS $9,000, saving $1,000 in taxes. The trick is that you pay income taxes on everything you withdraw. That $5,000 deposit multiplies over time, and turns into 100,000, and you pay income taxes on the 100,000 as you use it. Assuming the same 20% tax rate, you get to keep $80,000.
Roth IRAs are kind of the reverse. You deposit the money after tax, but it grows tax free. So if you earn 50,000, and pay 10,000 in taxes, your take home pay is 40,000 and your 10% contribution is $4,000 (trying to keep the math comparable with the above). This smaller deposit multiplies by the same amount, so it gets to 80,000.
The final account balance is smaller, but you don’t have to pay tax when you withdraw. In the IRA scenario, our guy paid $9,000 + $20,000 = $29,000 in taxes. In the Roth scenario, our guy paid just $10,000. These are round numbers with ludicrous growth rates and not necessarily realistic tax rates, but you can see the impact of tax-free investment growth.
Note that there are limits on deposits for retirement accounts, and significant penalties if you withdraw before you reach retirement age. I am not an investment advisor, and this is not personal investment advice, but it benefits most people immensely to take advantage of these types of accounts as they build wealth for retirement.
So normally when you invest money you have to pay taxes on whatever money you made. However with Roth IRA’s you can let money grow and when you take out the money you don’t have to pay taxes on the gains.
The caveats are you can only put in so much money each tax year and in order to not pay taxes on the gains you have to withdraw the money after you’re 60, for a first time home purchase, for college expenses, or for birth expenses.