Roth IRA Explained & Compared To 401K

by Banks

In this video Sam Farrington talks about his favorite retirement account: the Roth IRA. He is sure many of you have heard of it before, but he’s going to explain it in a little more detail and tell you why he loves it so much. He explains the concept of the Roth by comparing it to possibly one of the most well-known retirement accounts: the 401k.

So the way the 401k works, if your employer offers one, is that you normally tell the employer what percentage of your gross paycheck you want them to withhold and place in your 401k. Your gross paycheck is your entire paycheck before taxes are taken out of it. Know that often times the employer will match what you put in up to a certain limit, but for this comparison he doesn’t worry about that. So the money that you put into your 401k is put in before taxes are taken out of it, and your money in the account grow tax deferred. This basically means it is not taxed yet. Yet is the key word here.  When you get to retirement age and decide to begin drawing from your 401k account, all of that money (which has hopefully grown), is now subject to income tax. The government is not going to forget about all that growth while it was sitting in your 401k. They want their portion, and the rules state they get their portion when you start withdrawing.

Now the Roth IRA on the other hand acts a bit differently, so lets go back to your paycheck. When it’s payday you have your paycheck direct deposited into your bank account. So the money is physically in your bank account.  You contribute straight from your bank account directly into your Roth IRA. Now remember that the money that you place into your Roth IRA has already been taxed. That’s a key concept to understand. What you place in your Roth IRA will grow tax-free. You will receive all of the growth over time, and when you start withdrawing your qualified distributions the money is all yours. You don’t have to worry about giving Uncle Sam his cut because he already got his portion the day you got your paycheck.

Related: How Much Should I Save For Retirement In My 20s?

There are some restrictions on how much you can contribute. In 2014 each person could contribute $5,500 per year. Also to qualify you must make less than a certain amount. Again in 2014, if you were married and filed jointly, you had to make less than $191k to be eligible. If filing single you had to make less than $129k.  If you were age 50 and older, you could contribute an additional $1k per year as a catch up contribution for a total of $6,500.

Lets look at a typical scenario. Lets say you are 30 years old and you contribute $5,500 per year to your Roth IRA until age 70. Assuming an 8% return on your money, you would have $1.4 million in your Roth IRA that is all yours. You wouldn’t have to pay any taxes on that money.