Money Basics: What is a Roth IRA?

Welcome to Money Basics, Yahoo Finance’s new personal finance series offering quick explanations for some of the most important terms involving your money.

Roth IRAs are individual retirement savings accounts that work a bit differently from traditional IRAs. Unlike a traditional IRA or a 401(k), you do not contribute pre-tax dollars to a Roth IRA. The money grows in the Roth IRA tax-free into retirement. Essentially, you’re paying now for tax-free withdrawals later. The money you contribute can be withdrawn tax- and penalty-free after five years, but the gains on that money cannot be touched until you turn 59.5 years of age.

A Roth IRA is another way to save for retirement.

The Roth IRA takes its name from former Delaware Senator William Roth who sponsored the Taxpayer Relief Act of 1997. Roth’s bill created the framework for the account that bears his name.

Within the Roth IRA, your money can be invested in a number of different areas—stocks, bonds, mutual funds, ETFs or certificates of deposit. A general rule of thumb for investing in a Roth IRA is to try and diversify your holdings. Don’t put all your money in one stock or even one fund. Many investors will also rebalance their portfolios over time, so that the mix of stocks to bonds decreases as the investor near retirement.

As with any investment, Roth IRAs carry some risks. You could lose money in a Roth IRA if the market declines. Additionally, since Roth IRAs are funded with after-tax dollars, if you retire in a lower income bracket, you’ll miss out on the tax benefits of the Roth. Essentially, you would have paid more money in taxes on the dollars you contributed than the dollars you’d withdraw in retirement.

It’s possible to make too much money to open a Roth IRA. Individuals who make below $118,000 can contribute up to $5,500 a year to a Roth IRA. Individuals who make more than $133,000 aren’t able to contribute to a Roth IRA. Check with the IRS website before opening a Roth IRA to see if you qualify.

More from Money Basics:

What is a hedge fund?
What is the Fed?
What is an annuity?
What is a robo-advisor?
What is an ETF?

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