Why The ROTH IRA Is The Greatest Thing Since Sliced Bread

By January 26, 2017Finances, Investing, Planning, Roth IRA

Velcro. Internet. Two-ply toilet paper. Many things have claimed to be “the greatest thing since sliced bread.” Sliced bread was invented in 1928 by Otto Frederick Rohwedder from Davenport, Iowa. Alright ‘Merica! How did they survive before 1928?? Another blog topic I suppose. But today I want to talk and explain to you why the Roth IRA is, in fact, The Greatest Thing Since Sliced Bread.

Roth? IRA? Maybe you’ve heard the terms before, maybe not. If not, consider this your very lucky day. The Roth IRA is a type of investment account. What makes it so great? How about more money in your pocket? Interested?

To explain, let’s paint the picture first. Why do we invest? To earn more money of course! If you want to invest and earn more money you need a few things.

  1. Money – In order to invest and earn interest you need to have money to start with. Get to work!
  2. Investment Account – There are many types of investment accounts. It could be as simple as a savings account at your bank or more complex like an IRA or 401(k) at your company. Once you have money, you deposit it into an investment account.
  3. Investments – Once you have deposited money inside of an investment account, you can invest, or buy, investments that hopefully pay or earn you interest(more money).

Roth is the last name of the senator, William Roth who proposed the idea. IRA stands for Individual Retirement Account. So a Roth IRA is a type of investment account that I mentioned above in #2. So far, so good? 

I’m going to use Bob as an example. Bob works really hard for his money. Bob wants to be able to rent a catamaran and cruise around the British Virgin Islands with his wife and friends when he retires. That costs money. So Bob is going to start investing for his goal of cruising a catamaran around the Caribbean. Here are a few possible scenarios Bob could take.

Scenario 1: A Taxable Investment Account

I think in order to best explain what a Roth IRA is, we should look at what it isn’t and compare. A different type of investment account is a taxable account. A taxable account in Bob’s case would work like this:

  1. Bob works hard at his job and earns money. Go Bob!
  2. Uncle Sam (the government) taxes Bob on his income.
  3. Bob takes the remaining portion and deposits it in a taxable investment account.
  4. Bob purchases some investments in his taxable investment account.
  5. The investments earn Bob some interest.
  6. Uncle Sam taxes Bob’s interest.
  7. Bob withdraws his money to go cruising the Caribbean.

You can see why it’s called a taxable account. Taxes taken all over the place! This method results in Bob paying a high amount of taxes and keeping less of his hard-earned dollars.

Scenario 2: A Traditional IRA

The main feature of an IRA type account (as opposed to the taxable account) is that while the money is inside of the IRA account, no taxes are taken. It’s like a force field that protects your money from Uncle Sam. So basically while your money is inside the IRA, you have no taxes taken. There are special rules regarding when you can take a penalty-free withdrawals from the account that you need to be aware of. You can learn more about that here.

There are different types of IRA accounts. The Roth, which I’ll explain next, is one type. Another type is called the Traditional IRA. Depending on factors set by the IRS, you may be able to deposit money into a Traditional IRA before you pay any income tax. In Bob’s example, the Traditional IRA works like this:

  1. Bob works hard at his job and earns money. Go Bob!
  2. Before Uncle Sam taxes Bob on his income, he deposits it into his Traditional IRA.
  3. Bob purchases some investments in his Traditional IRA account.
  4. The investments earn Bob some interest.
  5. Bob retires and withdraws money from his Traditional IRA to pay for his catamaran trip around the British Virgin Islands.
  6. Bob pays Uncle Sam taxes on the amount he withdraws.

Notice how the only time Bob had to pay taxes was when he withdrew the money from his account. This money included both the portion that he initially deposited and all the interest he earned.

Scenario 3: The ROTH IRA

Are you ready for this?

The Roth IRA also keeps Uncle Sam from taxing while your money is inside the account. The ROTH IRA is different from the Traditional IRA in that taxes are taken out right away, not at the end. That means as long as you’re taking a qualified withdrawal, you pay no tax or penalty on the interest you’ve earned. But wait, there’s more! Any of the money you’ve deposited (your basis) in a Roth IRA can be withdrawn at any time, for any reason. In Bob’s situation it looks like this:

  1. Bob works hard at his job and earns money. Go Bob!
  2. Bob pays taxes on his income.
  3. Bob deposits what is left over into his Roth IRA.
  4. Bob purchases some investments inside his Roth IRA account.
  5. The investments earn Bob some interest.
  6. Bob retires and withdraws money from his Roth IRA to pay for his catamaran trip around the British Virgin Islands.

Notice how the only time Bob paid tax was when he initially earned income. When he withdrew the money from his Roth IRA, he did not pay any tax on any of the interest he earned. Pretty awesome if you ask me!

The BIG Difference

To guard your money from being taxed by Uncle Sam while you are investing, it might make sense for you to place it within the protective walls of the IRA. A Roth IRA allows you to pay your tax on the small amount right away and then make TAX-FREE WITHDRAWALS of interest later. Let me state that just one more time: TAX-FREE WITHDRAWALS. Since 1928, when sliced bread was invented, can you think of anything better? Didn’t think so.

There is a limit to how much you can deposit into your IRA account, which changes yearly based on the IRS. You can find more info here. Also, remember that there are only certain circumstances you can withdraw earnings without paying a penalty. The most common reasons you can withdraw and avoid a penalty are if you are older than 59 1/2, buying your first home, paying for education, or are suddenly disabled. You can read more about a qualified withdrawal here. If you are planning on using these savings for retirement after you turn 59 1/2, then there is no worries about the penalty. Plus, you always have the option of withdrawing the money you deposited in the Roth IRA at any time, for any reason.

Interested in the Roth IRA?

I’m sure you see now why the Roth IRA is so amazing and literally the greatest thing since slice bread. I try to keep things simple and that’s how I roll! If you have more questions I make it super simple to get answers, without having to talk to some high-pressure sales person. Just use my secure contact form to ask a question. Your question is confidential and you’ll get a friendly reply via email within 48 hours to help point you in the right direction.

I found a cool video from Kevin at Thousandaire that does a great job explaining just how AWESOME the ROTH IRA really is. I think you’ll enjoy it.

All the Best,

John

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