Q: I want to invest in a Roth IRA, but I don’t know how it works. Is it better than a regular IRA? I have a 401(k) plan at work, and am not sure what the difference is between them.
A: Other than the fact that a Roth IRA is also a retirement account, it’s very different from a 401(k).
Retirement accounts like a 401(k), 457(b), Keogh, SIMPLE, and conventional IRA are all accounts that you fund with pre-tax dollars. In other words, the way you contribute to these accounts is the cash is automatically deducted from your paycheck. So, they’re tax deductible, meaning that you pay less tax now because they lower your “taxable” income, and then they grow tax deferred. That means you don’t pay any tax until you withdraw the money years from now.
With a Roth IRA, you’re dealing with after-tax cash. You can put in up to $3,000 per year (or up to $3500 per year if you’re over the age of 50). This cash comes out of your savings, or your take-home pay. The nice thing about the Roth IRA is that the cash grows tax-free forever, there are some estate-planning benefits, and you can use the cash to pay for medical bills and tuition before you turn 59 1/2, which is the age at which you’re allowed to start making withdrawals without penalty. (You can also use cash from a Roth IRA or conventional IRA to purchase a first home.)
Just remember, that the Roth IRA is an account. Once you fund the account, you still have to choose an investment, whether you buy individual stocks, an index fund, bonds, shares in a real estate investment trust, or just leave it in cash.