What is a Roth IRA? Similar to a traditional IRA, a Roth IRA is a tax-advantaged account that allows investors to save for retirement and withdraw funds without penalty once they reach a certain age.

In this article, we’ll show you how to:

1. Determine if you are eligible
2. Find a home for your account
3. Provide the necessary information
4. Create an investment portfolio
5. Schedule regular contributions to your IRA

After learning how to start your own Roth IRA account, stay tuned for tips on how to maximize your new retirement account. 

1. Determine if you are eligible

According to the IRS, those who file taxes as a single individual and earn an annual modified adjusted gross income (MAGI) below $161,000 are eligible to enroll in a Roth IRA. If you file taxes with a spouse, your joint income must be below $240,000 to qualify. As the investor, you are responsible for making sure you are eligible to contribute to a Roth IRA based on these limits. An online broker for a Roth IRA will not limit your ability to make a Roth IRA contribution, even if you are ineligible for making a contribution based on your income. However, if you do contribute to a Roth IRA and you are not eligible, you should correct this mistake as soon as possible. You will face a 6% penalty each year until you remedy your mistake.

Your annual gross income will also determine if you are eligible to make the full IRA contribution limit of $7,000 or if you are subject to reduced contribution amounts.

Aside from the IRS eligibility criteria, consider tackling your debt and creating an emergency savings fund before investing in a Roth IRA. Using this strategy, you can focus on cultivating an early retirement game plan without the stress of lingering debt or unexpected expenses on your mind.

2. Find a home for your account

Remember, a Roth IRA is an account type, not an investment that lives within a retirement account. If you have little interest in maintaining your retirement account, consider housing your Roth IRA with an online broker.

The best Roth IRA accounts are ones that come fully equipped with tons of investment options. Here are some questions to consider while scouting for the best home for your Roth IRA account:

• Are you interested in passive or active retirement investment strategies? If passive, consider an investing platform. If active, opt for a DIY retirement savings account. A financial advisor can help you find the perfect match.
• Are there any opening or maintenance fees you should be aware of? Although it is generally free to open a Roth IRA account, some providers may have account minimums or transfer fees.
• Is there an abundance of investment options to choose from? Long-term investment accounts like a Roth IRA generally benefit from asset diversity. Ask your provider what kind of assets and investments are available.
• Is the investment platform well-suited for buying, selling, and trading investments? Active investors should know of any fees, restrictions, or settlement periods associated with investment transactions. Passive investors should also be prepared to handle any cost when it is time to liquify their assets.

Once you answer these questions, you will be able to learn how to open a Roth IRA on the platform of your choosing.

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3. Provide the necessary information

Setting up your Roth IRA account is a breeze when you have these necessary documents at your fingertips:

• A social security number (SSN)
• A valid driver’s license or state ID
• A bank routing number
• Your bank account number
• Employer’s name and address
• Beneficiary’s name, SSN, and address

4. Create an investment portfolio

Aim to diversify the investments within your Roth IRA account. A diverse array of assets within an investment portfolio is a common way to hedge against inflation and market volatility.

Here are a few of the most popular assets that investors can incorporate into their Roth IRA account:

• Stocks: earn dividends or payouts from shares of a business 
• Bonds: earn interest from the money you lend to an entity
• ETFs: benefit from value appreciation of a group of securities
• Mutual funds: pool your money together with other investors to buy a basket of securities

Your time horizon, income level, and financial goals will ultimately determine which assets are the best match for your Roth IRA.

5. Schedule regular contributions to your IRA

Unlike a traditional IRA, Roth IRA contributions are taxed before they go to your account. So, the sooner you add your contributions, the sooner your money can start to grow in a tax-free way.

Scheduling regular contributions to your Roth IRA account can ensure that you set money aside each month for your retirement goals. Before contributing, check with your hosting platform about their contribution limits and transfer costs. 

Although you have until the next tax filing date to add contributions, you can schedule regular contributions throughout the year. However, you are also allowed to make one larger contribution annually. Some investors may choose to wait until the end of the year so they understand their income if they are close to the income limits, or to make sure they have enough earned income to make a full contribution. Select the option that best fits your individual needs. 

Tips for maximizing your Roth IRA accounts

A Roth IRA is a long-term investment account that you can maximize in the following ways:

• Invest as early as possible
• Speak with a financial advisor
• Diversify the assets in your account
• Allow your contributions to compound
• Learn Roth IRA withdrawal rules
• Name a beneficiary

Since Roth IRA contributions are already taxed, you will be able to withdraw from your account tax-free after you reach age 59 ½. Contributing now will allow your investments to compound until then.

If a traditional IRA nor a Roth IRA sound capable of meeting your retirement goals, consider exploring the benefits of a self-directed IRA.

Take control of your tomorrow with an IRA.

Set aside money for retirement-and save on taxes-with a traditional or Roth IRA.

Learn more

FAQs about how to start a Roth IRA

Still have questions about how to start a Roth IRA? We’ve got answers.

What does IRA stand for?

IRA stands for individual retirement account.

How does a Roth IRA work?

Investors contribute taxed funds into their investment account and can then make tax-free withdrawals after they reach the age of 59 ½ years old.

How much money do you need to start a Roth IRA?

The answer depends on which Roth IRA account you choose. You will potentially have to pay registration fees, account minimums, trading fees, and withdrawal fees.

Can I open a Roth IRA myself?

Yes, you can open a Roth IRA on your own. However, you should speak with a financial advisor to ensure you are aware of the rules and obligations of the account.

Where can I open a Roth IRA for a beginner?

A beginner can open a self-directed account or a Roth IRA on an investment platform.

Can I open a Roth IRA at my bank?

Yes, you can open a Roth IRA at the same bank as your traditional IRA.

How much can you put in a Roth IRA?

You can make the full IRA contribution limit of $7,000 if you meet the IRS requirements. Those over age 50 can make an additional catch-up contribution of $1,000 for a total annual contribution limit of $8,000.

Is a Roth IRA or 401k better?

A Roth IRA might be a good option for investors who want to pay tax on their earnings today, in exchange for tax-free distributions in the future. If they plan to be in a higher tax bracket once they retire this can be a good strategy. However, if your employer offers a 401k matching contribution you may want to start investing in the 401k until you qualify for the maximum matching contribution from your employer. This will increase your retirement savings by accumulating dollars contributed from your employer. Everyone’s situation is unique, and the answer depends on your financial goals, tax situation, and retirement plans.

The post How to Start a Roth IRA: A 5-Step Guide for 2024 appeared first on Stash Learn.

It’s called an “individual” retirement account (IRA) because you, as an individual, set up and manage it on your own. It’s not something your employer handles for you, like a work-related retirement plan. 

But what exactly is a traditional IRA, and how does it work? Let’s find out.

In this article, we’ll cover:

• What a traditional IRA is
• How traditional IRAs work
• Traditional IRAs vs other IRAs
• Pros and cons of traditional IRAs
• How to open a traditional IRA account

What is a traditional IRA?

A traditional IRA is a type of retirement account that offers tax advantages. When you contribute money, you’re often able to deduct that amount from your income taxes. This helps to lower your taxable income for the year.

For example, if you earn $50,000 a year and contribute $7,000 to a traditional IRA, your taxable income would be $43,000. This can potentially save you money on your tax bill.

A traditional IRA is best if:

• You want to lower your taxable income now
• You expect to be in a lower tax bracket in retirement

How traditional IRAs work

Anyone with earned income can contribute to a traditional IRA—there are no income restrictions. You can open a traditional IRA with Stash, your bank, or any other brokerage firm. 

When you put money into a traditional IRA, it’s not just sitting there idly. You get to decide how to invest it. You can invest IRA funds in various ways, like stocks, bonds, exchange-traded funds (ETFs), and other securities. 

The money inside a traditional IRA grows tax-deferred. This means you won’t pay taxes on it until you withdraw the money in retirement. Over the long term, this tax-deferred growth can help you build wealth.

Contribution limits

The annual contribution limit to a traditional IRA is $7,000 as of 2024. If you’re 50 or older, you may make an additional $1,000 catch-up contribution, for a total of $8,000 annually.

There are two caveats, though:

1. If you earn less than the current year contribution limit, you can only contribute up to the total of your earned income for the year. So if your earned income is $3,000, your cap is $3,000.
2. This limit applies to traditional and Roth IRAs combined. So if you have both accounts, your total contribution cannot go over this limit.

Tax deduction

Traditional IRA contributions are typically made with pre-tax dollars, so you can get an immediate tax benefit by deducting them from your taxable income for the year. Doing so might put you in a lower tax bracket or make you eligible for certain tax incentives.

If you don’t have an employer-sponsored retirement plan, like a 401(k) or 403(b), you can deduct the entire amount you’ve contributed for the year. However, if you or your spouse participate in an employer plan, you might not be able to deduct the full amount. 

The IRS sets deduction limits based on your filing status and modified adjusted gross income (MAGI). If you’re single and have a workplace plan, your MAGI must be below $87,000 to receive at least a partial deduction. If you’re married and filing jointly, you must earn less than $143,000. This income limit applies even if your spouse has a workplace plan, but you don’t.

Age limits

Before 2020, you couldn’t contribute to a traditional IRA past age 70½. But now, there is no age limit. Anyone with earned income can contribute to a traditional IRA. This change was due to the SECURE Act, which went into effect on January 1, 2020. 

Early withdrawal rules

Generally, you can start taking funds out of your traditional IRA when you turn 59½, and you’ll pay regular income tax when you make withdrawals. 

If you take out money early, however, you’ll usually have to pay a 10% penalty on top of income tax. There are a few exceptions to the IRA early withdrawal rule, including:

• Becoming totally and permanently disabled
• Paying for certain higher education expenses
• Buying your first home, up to $10,000
• Paying health insurance premiums while unemployed
• Taking substantially equal periodic payments (SEPPs) for at least five years or until you turn 59½, whichever comes later

Check out IRS Publication 590-B for important information on these and other exceptions.

Required minimum distributions (RMDs)

Once you reach a certain age, you’re required to start taking withdrawals from your traditional IRA each year. This age has gradually increased through various legislation over the past four years. Currently, if you reach age 72 after Dec. 31, 2022, then you must start making withdrawals at age 73.  These withdrawals are called required minimum distributions (RMDs), and they’re based on your life expectancy and IRA account balance.

If you don’t take RMDs, you could pay a hefty excise tax of up to 50% of the amount you were supposed to withdraw. So make sure you plan ahead and take your RMDs on time.

Pros and cons of contributing to a traditional IRA

Traditional IRA benefits

An IRA of any kind can help you put away money for retirement and possibly enjoy tax advantages. The particular benefits of the traditional IRA include:

• Your tax-deductible contributions can lower your taxable income for the year, and may even drop you into a lower tax bracket. 
• You pay no taxes on funds while they’re invested, meaning there’s more money in the account to compound over time.
• If you’re in a lower tax bracket when you make withdrawals than when you made contributions, you may pay less tax on your money overall.  
• You can invest in the stock market through a wide variety of securities, including stocks, mutual funds, and ETFs.
• There’s no income limit; you can put money into a traditional IRA no matter how much you make. 
• Some exceptions allow you to avoid the early distribution penalty. 

Disadvantages of traditional IRAs

Depending on your circumstances, there may be some downsides to a traditional IRA compared to other types of IRAs, including:

• Withdrawing before you reach 59½ years of age may result in a 10% penalty
• There are yearly limits on how much you can contribute
• You must take required minimum distributions after age 73
• Possible limits on tax deductions if you or your spouse have an employer-sponsored retirement plan

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How traditional IRAs differ from other IRAs

There are several different types of IRAs, both for individuals and employees. The terms of each differ based on eligibility, contribution limit, income limit, tax treatment, and a few other factors. The comparison chart below reflects information as of 2024 for four common types of IRAs.

Roth IRA

A Roth IRA is similar to a traditional IRA in many ways: it’s an individual retirement account that offers tax advantages as long as you leave your money in it until you turn 59½. The main difference between a traditional and a Roth IRA is when the money is taxed. When you start a Roth IRA, you pay income tax on money before you invest it. Then, when you make qualified withdrawals, you don’t pay any income tax at all, including on the money your account has earned. You’re also allowed to withdraw funds you’ve contributed at any time without penalty, though you’ll be subject to a 10% penalty if you withdraw earnings early.

A Roth IRA is best if:

• You want tax-free income in retirement
• You believe your tax rate will be higher in the future

SIMPLE IRA

The Savings Incentive Match Plan for Employees, or SIMPLE IRA, allows an employer to set up traditional IRAs for their employees; both the employer and employee can make contributions. It’s generally available for small businesses with fewer than 100 employees that don’t have another retirement savings plan, like a 401(k). If your employer offers a SIMPLE IRA, they’re required to contribute a certain amount each year, but you don’t have to put in any money. 

A SIMPLE IRA is best if:

• You’re a small business owner or work for a small business and want an uncomplicated way to save for retirement.

SEP IRA

The Simplified Employee Pension Plan, or SEP IRA, is a retirement account that can be established by either an employer or a self-employed person. Unlike the SIMPLE IRA, only an employer can contribute to a SEP IRA. The employer is allowed to take a tax deduction for contributions made, and they must contribute equally to all eligible employees. Note: if you’re self-employed, you are considered the employer, so you can make contributions and take tax deductions.  

A SEP IRA is best if:

• You’re self-employed or own a small business and want a simplified way to save for retirement while potentially contributing more than traditional IRA limits.

Rollover IRAs

If you have an employer-sponsored retirement plan and leave your job, you can usually do what’s called a rollover, in which you transfer the funds from your retirement plan into an IRA. Most people are eligible to roll over funds into either a traditional or Roth IRA, but there can be tax implications if you’re rolling over pre-tax (traditional) money into a Roth IRA. If you’re trying to decide what to do with your 401(k) or 403(b), you may want to brush up on the IRS rules for rollovers. 

A rollover IRA is best if:

• You’re leaving a job and want to consolidate your retirement savings from an employer-sponsored plan.

How to open a traditional IRA account

To get started with your very own IRA, follow these key steps:

Pick the right IRA provider

The first step to opening a traditional IRA is to pick a reliable provider. Research different options, like banks, online brokers, or Stash IRAs. Choose a provider that suits your investment needs and preferences.

Open your account

Once you’ve chosen a provider, complete the online application process to open the account. This usually takes 15 to 20 minutes, during which, you’ll be asked to give your name, address, and Social Security number to verify your identity.

Choose your contribution amount

Decide how much money you want to put into your IRA each year. The maximum contribution limit for 2024 is $7,000 or $8,000 if you’re at least 50. Remember, you’ll also be limited by your amount of earned income.

Select your investments

In a traditional IRA, you can invest in a variety of assets like stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Research and choose investments that suit your risk tolerance and financial goals. Stash has automatic investing tools to help you build wealth regularly. 

Monitor and adjust

Review your account’s performance and make adjustments as needed. This might mean rebalancing your investments or changing your contribution amounts. 

Use a retirement calculator to determine how much you’ll need to save for retirement based on your age and desired retirement income. This will help you set a realistic savings goal and plan for a comfortable retirement.

Is a traditional IRA right for you? 

The sooner you start investing for the future, the more time your money has to grow. When you’re deciding whether a traditional IRA is the right choice for you, you might consider things like:

• Flexibility: Are you able to leave your funds in your account until retirement age to avoid incurring penalties? 
• Tax deductions: Do you want to lower your tax bill now or pay less tax in the future?
• Income limits: Do you have a higher income level that might disqualify you from opening a Roth IRA?

When it comes to tax-advantaged individual retirement accounts, people are often weighing the pros and cons of a traditional IRA vs. a Roth IRA. Good news: you can have both.

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Frequently asked questions

1. What are the annual contribution limits for a traditional IRA?

In 2024, the maximum you can contribute is $7,000 or $8,000 if you’re 50 years or older. It’s essential to stick to these limits; there may be penalties if you go over them.

2. What happens if I contribute more than the annual limit to a traditional IRA?

If you contribute more than the annual limit to a traditional IRA, you might face a penalty of 6% on the excess amount every year until it’s corrected. This penalty can add up quickly, so if you accidentally over-contribute, correct it as soon as possible.

3. Can I have both a traditional IRA and a 401(k) plan?

Yes, you can contribute to both a traditional IRA and a 401(k) in the same year. However, your ability to deduct your traditional IRA contributions from your taxable income may be limited if you or your spouse is covered by a workplace retirement plan.

4. Should you contribute to a traditional IRA if it’s not tax-deductible?

Even if you can’t deduct your IRA contributions from your tax return, it might still be worth it to contribute. The primary reason is that you can still grow potential earnings tax deferred. But if you’re looking for alternatives, consider opening a Roth IRA or increasing contributions to your 401(k), especially if you have access to an employer match. 

5. What happens to a traditional IRA when you die?

Your traditional IRA will pass to your designated beneficiaries when you die. They will have the option to take account distributions over their lifetime or as a lump sum. If you don’t designate a beneficiary, your traditional IRA will go through probate, which can be a lengthy and expensive process.

6. Who cannot open a traditional IRA?

Individuals who don’t have earned income, like wages, salaries, or self-employment income, cannot open a traditional IRA. One exception is if you’re married and your spouse works. In this case, your spouse can contribute to a traditional IRA on your behalf when you file a joint tax return. This is known as a spousal IRA contribution.

The post What Is a Traditional IRA? appeared first on Stash Learn.

The average American retires with $200,000 to $250,000 between various retirement savings accounts—just a measly one million dollars shy of the recommended amount. This explains why so many retirees return to work either part-time or full-time—34% of the American workforce is 65 or older, with almost 9% being 75 or older.

For some people, retirement can seem like an impossibility. Even retiring by the standard retirement age of 65 can seem out of reach.

While we all have different ideas of what retirement can or should be—from moving into an old missile silo to long days spent playing bird bingo with the grandkids—everyone eventually hopes to punch the clock one last time and enjoy life without work.

But getting there takes resources and planning. Specifically, how much you’ll need in retirement savings.

How much do I need to retire?

The most common recommendation to save for retirement is between $1.2 and $1.5 million. However, if you are hoping for an exact amount, there isn’t a one-size-fits-all number. Everyone has different retirement goals and methods of reaching them. Though, there are formulas to use as starting points to determine how much you’ll need in retirement.

The table below lists a 20- to 35-year retirement plan with access to 80% of pre-retirement salary. For example, to retire early at 50, an individual earning $50,000 a year should have $1.4 million in their retirement account to support a 35-year retirement. If that person were to retire at 60, they would need $1 million in retirement savings.

Two important considerations for early retirement:

• Some retirement accounts penalize withdrawals before 59 ½. You can contribute more to account for the penalties or plan on how to pay for it.
• Realistically, if an individual retires early, they don’t solely rely on their retirement funds. Setting up a steady stream of passive income is a common way retirees bring in money while enjoying retirement.

How Much Do You Need to Retire: By Income

How to calculate retirement savings

While the numbers above are a good benchmark for how much you’ll need in retirement by age, the exact amount varies on your specific situation. Many free tools can help you calculate exactly what you need.

Savings calculators can help you see how much money you need to set aside each month to reach your financial goals and retire by 65 or any other age. Check out Stash’s retirement calculator. Simply plug in your age, income, and current savings, and it can help you calculate how much you’ll need to save to reach your retirement goals.

How much do you need to retire?

Use our retirement calculator to find out.

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Try playing with these calculators and inputting different numbers to see what’s possible. Even minor changes to your saving and spending habits can greatly affect the eventual outcome.

If your salary isn’t in the table above or you are a couple looking for your combined retirement savings benchmark, use the following calculations.

High earners should consider contributing on the higher end of the scale to maintain their typical lifestyle while in retirement. For example, the retirement account of a Chief Financial Officer making $275,000 a year should hold about $2,200,000—eight times their salary—when they turn 55.

Retirement Savings Benchmark By Age

How to save for retirement

There are numerous ways you can start saving for retirement. If you’re looking to build your wealth by investing for retirement, the most common retirement investment accounts are 401(k)s, Roth IRAs, and traditional IRAs. Stay with us as we break each one down.

401(k)

A 401(k) plan is an employer-sponsored retirement plan offered to employees. Contributions are invested and grow over time. However, the employer and plan provider determines what investment options are available.

401(k)s can be either traditional or Roth—about 88% of 401(k) plans offer a Roth version. The main difference between the two is how they’re funded. Those enrolled in traditional 401(k)s contribute pre-tax dollars, whereas Roth 401(k)s use after-tax dollars.

While both traditional and Roth 401(k) employee contributions are generally eligible for an employer matching contribution (if available), the employer’s contribution will be deposited as traditional 401(k) funds. Approximately half of all employers offer some degree of matching.

Traditional IRA

A traditional IRA is a tax-advantaged retirement account where investors contribute pre-tax dollars into investment types like stocks, bonds, and mutual funds. Balances grow tax-deferred, meaning investments accumulate tax-free until withdrawn. If you expect to be in a lower tax bracket after retirement, a traditional IRA might be best for you.

Roth IRA

A Roth IRA is another type of investment retirement account, but unlike traditional IRAs, Roth IRAs are funded by after-tax dollars. After contributing, investments continue to grow tax-free and do not face further taxes when withdrawn. Stocks, bonds, and mutual funds are also common Roth investment types.

Roth IRAs are appealing due to their high-growth nature. If you started maxing out your Roth IRA in your twenties, you could retire as a millionaire in your sixties.

However, Roth IRAs have high-income eligibility limits meant to prohibit those earning over $161,000 from profiting from Roth tax benefits. However, high earners can get around this stipulation by converting a traditional IRA to a backdoor Roth IRA.

Retirement savings considerations

Think ahead, and consider the costs related to your future retirement plans. Bills don’t go away when you retire, so you need a plan for how you’ll pay living expenses like healthcare and property taxes. There are also factors beyond your control that impact your retirement savings, like where you live and inflation.

1. How much can you contribute?

You shouldn’t put yourself in financial trouble now to save for retirement. But that doesn’t equate to skipping out on saving for retirement altogether. Analyze your financial standings and create a budget to determine how much you can contribute to your retirement savings. Remember, some retirement savings is better than none.

2. Where do you want to retire?

Perhaps the biggest factor in figuring out how much you’ll need to retire is where you hope to live. Ask yourself:

• Do I plan on downsizing and moving into a smaller house? Selling your home for a smaller, cheaper one may provide additional extra money for your retirement savings.
• Will I move to a different country? A European villa will cost much more than a small house in Indiana or Ohio.
• If I don’t plan on moving, will my maintenance costs, property taxes, and home improvements rise with time?

Think about where and how you want to live to understand how your cost of living might change. Also, if you plan on moving away from friends and family, you could spend more on frequent trips to visit—just one more thing to consider.

3. What do you envision retirement to be?

Another important question to ask yourself: “What do I want to do when I retire?”

For example, if you hope to retire at 65 and spend your retirement golfing at the local country club, you’ll need far less than the person who retires at 50 and travels the world.

Read more: How to calculate opportunity costs

4. How can you account for inflation?

It’s impossible to know how much the prices of goods will increase over time, making it difficult to plan for inflation in retirement savings. You could look at historical inflation rates, but even that might not be a completely accurate prediction of the future. For example, the COVID-19 pandemic, which led to inflation spikes in 2022, couldn’t have been predicted.

The best way to account for inflation in your retirement savings is to save for more than you’ll need if you can afford to. Additionally, Social Security increases with inflation, though this shouldn’t be your primary source of income in retirement.

Frequently Asked Questions (FAQ)

Still have questions about how much you’ll need in retirement? Let us help!

How much does a couple need to retire?

On average, couples should have about eight to 10 times their combined pre-retirement salaries saved for retirement. For high earners, that amount should be closer to 15 times their combined salaries.

Can I retire with $1.5 million comfortably?

Yes, it’s possible to retire with $1.5 million and live a comfortable life if you retire at a typical retirement age. However, this is only true for those used to living with a salary of less than $100,000.

Can I retire at 60 with $500,000?

It’s not impossible to retire at 60 with $500,000 if you live a frugal lifestyle. This savings amount would provide a $16,000 to $25,000 annual salary. But people retire with much less. The average American has less than half this amount in their 401(k) accounts.

However, if you want to truly retire and not pick up a part-time job, you would need much more savings. Or, you may consider putting passive income streams in place to supplement your retirement savings.

Why you should start saving now

Now that you’ve calculated how much you’ll need in retirement to live comfortably, it’s time to get started saving. Compound interest can heavily impact long-term retirement savings, which is why it’s important to start saving early to reach your goals.

The earlier you start saving, the more time your money has to compound and the more interest or returns you could earn. Even if your current contributions are small, compounding can help them add up by the time you reach 65.

The sooner you start, the better. Saving small amounts over longer periods is typically easier than scrambling to save several thousands of dollars per year in your 50s and 60s. Starting to save at a young age could give you a huge head start.

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The post How Much Do I Need to Retire: A Guide for Retirement Saving [2024] appeared first on Stash Learn.

You’ve heard it before—it’s never too early to start saving for retirement. The earlier you start, the more comfortable you’ll be sitting on a beach with the rest of the snowbirds in Florida. But how do you start stashing away for your later years?

Individual retirement accounts (IRAs) are one of the most common types of investment accounts. If you’re debating between a Roth IRA vs. traditional IRA, you’ll want to consider the pros and cons of each. Both offer tax benefits, but they differ in important ways, including the timing of those tax benefits, accessibility of funds, and income limits.

Read along to learn the pros and cons of Roth vs. traditional IRAs to determine which is best for you.

Comparing Roth vs. Traditional IRA

What is a Roth IRA?

A Roth IRA is an individual retirement account you fund with after-tax income. This is separate from an employer-sponsored retirement plan. You can reap tax benefits by keeping your money in the account until retirement age. Your money grows tax-free while in the account and you don’t pay any taxes on withdrawals after age 59½. Plus, you can withdraw funds you’ve contributed at any time without penalty (early withdrawals on earnings are subject to a 10% tax penalty).

Benefits of a Roth IRA

Saving for retirement with a Roth IRA can have some notable advantages.

1. Tax-free growth and earnings

In exchange for contributing after-tax dollars, your money grows tax-free. Basically, you pay your taxes on contributions up front, let your money compound, and then pay no taxes when you withdraw earnings after age 59½.

Note that this tax benefit is subject to the five-year rule: you must hold a Roth IRA for five years, or earnings you withdraw may be subject to taxes and penalties. If you have multiple Roth IRAs, once you satisfy the five-year rule for the first one you open, the IRS generally considers the rule satisfied for all of them, even those you opened more recently.

2. Withdraw contributions penalty-free

At any time, you can withdraw the money you’ve contributed without paying penalties or additional taxes. That flexibility can be helpful, but remember that it applies to contributions only; any earnings on your investments will usually be subject to taxes and penalties if withdrawn early.

3. No required distributions

Required minimum distributions (RMD) force you to make withdrawals from your account annually starting at a certain age. Roth IRAs don’t have RMDs, allowing your money to compound for as long as you like. You can even pass along the untouched money to your heirs, tax-free.

Disadvantages of a Roth IRA

When you’re considering a Roth IRA, you may want to take into account the potential downsides.

1. Contributions are not tax-deductible

Because you’re contributing after-tax dollars, your annual Roth IRA contribution isn’t tax-deductible at the end of the year, meaning your contributions don’t reduce your taxable income in the year you make them.

2. Taxes and penalties for some withdrawals

While you can withdraw contributions to your Roth IRA without penalty, you may owe income tax and a 10% penalty if you withdraw earnings before you’re 59½ years old. There are, however, a few exceptions to IRA withdrawal penalties.

3. Limited annual contributions

In 2024, Roth IRA contributions are limited to 7,000 per year until age 50, at which point you can start contributing up to $8,000 annually. If you earn less than the contribution limit, you can only invest up to the amount of your earned income for the year. Contribution limits may also be reduced based on how much money you make. See the next item.

4. Annual income limits

The IRS restricts your ability to contribute to a Roth IRA based on your income. For instance, single filers earning over $146,000 in 2024 are limited to making a reduced Roth IRA contribution. Once they earn over $161,000 (in 2024), they are not eligible to contribute to a Roth IRA at all. 

The contribution limit starts to reduce for joint filers when their earnings reach $230,000, and they are not eligible to contribute to a Roth IRA when they’re income reaches $240,000. Income in this case is measured by your Modified AGI (MAGI). 

There is a loophole for high earners to get around the income limit while still reaping tax benefits. This is known as a backdoor Roth IRA. This strategy allows individuals to make contributions to a traditional IRA and then later convert the account into a Roth IRA. Conversions aren’t subject to income thresholds but are still subject to contribution limits. You should consult with a financial planner or tax advisor before making a backdoor Roth contribution, because if done incorrectly it may result in an unwanted tax liability.

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What is a traditional IRA?

A traditional IRA is also a tax-advantaged individual retirement account, but it functions differently than a Roth IRA. You may contribute pretax dollars, and your investments grow tax-deferred until you withdraw them during retirement.

Generally contributions are tax-deductible which can lower your taxable income for the year. After age 59½, you can withdraw your contributions and earnings and pay income tax on your money at that time.

Benefits of a traditional IRA

For some investors, the benefits of a traditional IRA outweigh those of a Roth IRA.

1. Tax-deferred growth

Once the money is in your traditional IRA account, it grows tax-free. Earnings and gains are not taxed until you make a qualified withdrawal during retirement. This can be an appealing tax benefit because many people are in a lower tax bracket after they retire.

2. Tax-deductible contributions

Note that if your or your spouse are eligible to participate in an employer-sponsored retirement plan, like a 403(b) or 401(k), it can impact the deductibility of your traditional IRA contributions. As of 2024, single filers who are covered by a workplace retirement plan, and with incomes over $77,000 ($230,000 for married filing jointly) may face limitations on the amount they can deduct. For married individuals filing separately, the income threshold is notably lower; those earning over $10,000 might not qualify for a full deduction of their traditional IRA contribution.”

3. No income limits

Anyone with earned income can contribute to a traditional IRA, regardless of how much you make.

Disadvantages of a traditional IRA

A traditional IRA tends to be a bit less flexible than a Roth IRA. Depending on your circumstances, that might be a disadvantage.

1. Penalties for early withdrawals

Unless you qualify for an exception to early-withdrawal penalties, any withdrawals from a traditional IRA before age 59½ are subject to income tax and an additional 10% penalty. That applies to both your contributions and gains.

2. Limited annual contributions

The contribution limits for 2024 are the same as Roth IRAs: $7,000 or $8,000 if you’re over 50.

3. Required minimum distributions

As of 2023, RMDs must be taken from a traditional IRA each year once you turn 73. The RMD for each year is calculated by dividing the IRA account balance as of Dec. 31 of the prior year by the applicable distribution period or life expectancy.

Roth IRA vs. Traditional IRA: Key Similarities

IRA pop quiz: Check your knowledge

Test your knowledge of Roth vs. traditional IRAs by answering true or false to the following questions in this quick pop quiz.

1/4

Quiz

 

With which type of IRA do you pay taxes when you contribute money to the account?

Roth IRA

Traditional IRA

Roth IRA. You contribute to a Roth IRA with post-tax dollars and you contribute to a Traditional IRA with pre-tax dollars.

2/4

Quiz

 

Which type of IRA requires you to withdraw money from your IRA at a certain age?

Roth IRA

Traditional IRA

Traditional IRA. Traditional IRAs require you to withdraw a certain amount of money at a certain age, called a required minimum distribution (RMD).

3/4

Quiz

 

At what age are you required to withdraw required minimum distributions from your Traditional IRA?

59 ½

62 ½

67 ½

70 ½

70 ½. You got it! You’re required to withdraw RMDs at age 70 ½ if your birthday is before June 1, 2019, or age 72 if your birthday is June 1, 2019 or later. 

4/4

Quiz

 

True or False: You can have both a Roth and a Traditional IRA.

True

False

True. Just make sure you don’t exceed the annual total contribution limit.

 

Quiz

 

You scored 

Share this quiz with others!

Next Question

How to choose between a Roth vs. traditional IRA

You have many options when saving for retirement, and an IRA of any type could offer tax benefits. When deciding between a Roth or traditional IRA, ask yourself the following questions:

1. Am I eligible for an IRA? Do you meet the income requirements to open an IRA account?
2. How much can I contribute? Roth IRAs and traditional IRAs hold the same contribution limit. But if you can afford to max out on IRA contributions on an IRA, it makes the most sense to opt for a Roth IRA and avoid paying taxes later.
3. Am I close to retirement age? A traditional IRA might be best if you’re within five to 10 years of retirement. The tax-free growth benefit of Roth IRAs works better if you have a long time before retirement.
4. Do you foresee your IRA as a potential nest egg for heirs? Since Roth IRAs don’t require minimum distributions, you can pass them on to heirs. You cannot do this with traditional IRAs.
5. Do you want your IRA to benefit you now or later? Traditional IRAs offer immediate tax benefits since they count as tax deductions, putting more money in your pocket now but leaving you to pay taxes down the road. With Roth IRAs, you reap the tax benefits later. You have to decide whether you prefer the extra cushion now or later.
6. Do you want flexible access to your money before retirement, just in case? Roth IRAs allow you to withdraw penalty-free from your contributions five years after opening the account. With a traditional IRA, nonqualified distributions incur tax and a 10% penalty.

For many investors, a deciding factor is whether you want to pay taxes now or in the future. You may want to consider whether your annual income and tax bracket will likely be higher or lower when you retire than it is now.

• If you think you’ll be in a higher tax bracket when you retire, a Roth IRA may be right. Your tax rate will be lower now, and you can withdraw those funds, plus earnings, tax-free in retirement.
• If you think you’ll be in a lower tax bracket when you retire, a traditional IRA may be the right choice. You’ll get the tax deductions today and pay a lower tax rate on your money later.

Saving for retirement is generally a good idea, and the right investment option for you depends on your current circumstances and goals. The tax benefits of both Roth and traditional IRAs could help your investments grow, so whichever you choose may help you build a brighter financial feature.

FAQ

Still unsure about which type of IRA you should have? Let us help.

Can you have multiple IRAs?

As long as you meet the eligibility requirements, you can invest in both a Roth IRA and a traditional IRA. You can also hold multiple Roth IRAs or multiple traditional IRAs. However, your combined annual contribution to all your IRA accounts will still be capped at $7,000 or $8,000 if you’re over 50.

Can my employer match my IRA contributions?

Employers cannot contribute to your individual Roth or traditional IRA because they are set up by you as an individual, separate from your employer plan. However, your employer can offer a different type of IRA plan, including an employer match. Smaller businesses often use these plans to help employees save for retirement without the costs of more complex plans like 401(k)s.

• Payroll Deduction IRA: This allows you to contribute to your Roth or traditional IRA through direct deposit from your paycheck. There is no option for an employer match.
• Simplified Employee Pension (SEP): This type of IRA allows an employer to open and contribute to an IRA for you. You cannot make contributions yourself; all the funds come from your employer.
• SIMPLE IRA plan: These plans are designed for small businesses that want to offer an employer match. Your employer must make matching contributions; plus, they have to contribute some funds even if you don’t.

Which IRA is right for you?

Whether you should choose a Roth or traditional IRA depends on your circumstances and goals. A Roth IRA may work well for you if you want more flexibility with your money and anticipate being in a higher tax bracket when you retire. A traditional IRA may be a better investment option if you want tax deductions now and expect to be in a lower tax bracket upon retirement.

Once you’ve decided which IRA is best for you, you’ll need to set a retirement investment strategy. Try our retirement calculator for a guided look into how much you’ll need to retire and the monthly contributions to get you there.

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While retirement may seem far away, and you have many expenses between where you are now and the life you want in the future, it can take decades to save the money you need for your golden years. The earlier you start, the easier it is to reach your goals. 

According to the Federal Reserve’s 2022 Report on the Economic Well-Being of U.S. Households, only 31% of non-retirees reported thinking their retirement savings were on track. And 28% reported having no retirement savings at all. 

Luckily, how you plan for retirement is a process that can be adapted to fit your lifestyle, age, and goals. And it’s never too late to get started. 

In this article, we’ll cover: 

• Considerations for retirement planning
• 5 steps for retirement planning

Retirement planning considerations

How you plan for retirement will be heavily impacted by several factors in your current lifestyle, as well as the needs you anticipate when you retire. Consequently, your retirement planning isn’t going to look the same as your friends, parents, or neighbors. You’ll want to consider factors like: 

• Your age and how far you are from retirement
• The age at which you want to retire
• Your current income and savings 
• Your projected future income
• Whether you plan to get married or have dependents
• Your health and the health of those in your immediate family
• Where you expect to live
• Your existing debt
• Your lifestyle and goals

Of course, you don’t have a crystal ball that allows you to see the future, so you can’t predict everything. But you can adjust your retirement planning as these factors change.

It’s worth noting that the federal government’s definition of retirement age is 62 for social security benefits and 59½ for most retirement-specific accounts like IRAs. That means that at 59½, you can withdraw money from your retirement accounts penalty-free, and at 62, you can start to receive social security benefits. You’ll want to factor these ages into your retirement planning, especially if you hope to retire early. 

How to plan for retirement in 5 steps

This five-step process will help you define what retirement planning looks like for you. You’ll want to tailor your investment plan to your specific lifestyle and goals and revisit your plan when major life changes occur.

Step 1. Figure out how much money you need to retire

A 2023 survey reported that Americans with 401(k)s estimate they’ll need, on average, $1.7 million to retire comfortably, but that figure will vary quite a bit per individual. Many experts suggest that retirees will need about 80% of their annual pre-retirement income to maintain their lifestyle in retirement. 

You can use the Stash retirement calculator to zero in on how much money you need to save before you retire. Gather the following info to make your calculations:

• The age at which you want to retire
• Your annual pre-tax income
• Your current retirement savings
• How much you can contribute to a retirement account each month

You may also want to think through what you want your future to look like. The amount of money you realistically need to retire depends on the lifestyle you hope to live in the future. For instance, many retirees downsize from a house to a condo, which lowers their living expenses. A good monthly retirement income is based on the expenses you’ll need to cover once you leave the workforce.

Step 2. Take stock of your assets, debts, and income sources

If you’re starting your retirement planning now, you’ll want to start by looking at your overall networth. How much money do you have in savings? How much debt do you have? You can position yourself for long-term success by paying down any high-interest debt and building an emergency fund now. That way, you aren’t passing financial hurdles on to your future self.

You’ll also want to think about the assets and debts you expect to have at retirement age. Consider whether your home will be paid off, if you’ll own a business, and if you’ll have any extra sources of income (like a rental property or other investments). You may also want to estimate your income from social security benefits using the Social Security Administration’s calculator. 

The age at which you plan to retire is an important consideration here, as it can affect the income sources you’ll have available. For instance, if you want to retire early, keep in mind that accessing your retirement accounts before you reach age 59½ may incur penalties, and you can’t receive social security benefits until you turn 62.

Step 3. Build retirement savings into your budget 

Saving enough for retirement might sound daunting, but you can get there by consistently putting aside money every month over the course of many years. That’s where your budget comes in: plan to save a portion of every single paycheck for retirement.

How much do you need to save every month? The rule of thumb is to save at least 15% of your pre-tax salary for retirement. The 15% rule is based on the assumption that you’ll start saving for retirement at age 25 in order to retire by 62 or age 35 to retire by 65. Investors who start retirement planning later in life might want to accelerate their savings by putting 20% or even 30% of their income into retirement accounts.

The amount you can save will depend on your current income and expenses. This chart can help you determine the dollar amount you should invest for retirement based on your income. If you can’t put aside at least 15% of your income at the moment, that’s okay; any amount of savings is better than none. Budget for what you can afford now, and increase that amount as your income grows or you find opportunities to reduce your expenses.  

Step 4. Set up retirement accounts

While you could technically store your retirement savings in a savings account or under your mattress, that would be an inefficient way to grow your money. Many investors store their retirement savings in tax-advantaged retirement accounts where their money can go to work earning returns. 

• 401(k) or 403(b): These are employer-sponsored retirement accounts that allow you to set aside a portion of your paycheck before taxes are taken out. Contributions are capped at $23,000 per year for 2024, and employers may match a portion of your contributions. 
• Solo 401(k): A Solo 401(k) is designed for self-employed workers and mimics many of the features of an employer-sponsored plan. The 2024 contribution limit is higher at $69,000, but you don’t get employer-matching benefits. 
• Roth or traditional IRA: IRAs are among the most common types of investment accounts. Investors can only contribute to a Roth IRA if they have an income limit below $161,000 (single filers) or $240,000 (joint filers), and contributions are made post-tax. You don’t pay any taxes on qualified withdrawals after the retirement age of 59½. Traditional IRAs, on the other hand, have no income limits, and contributions may be tax deductible, in which case you can delay paying income tax until you withdraw your money from a traditional IRA in retirement. The two accounts have a total contribution limit of $7,000 annually (those over age 50 can make an additional catch-up contribution of $1,000 per year).
• Self-directed IRA: This account type functions like other IRAs, but allows you to invest in more types of assets, such as precious metals, commodities, private placements, real estate, and more.
• Simple IRA: A Simple IRA is a savings incentive match plan for employees that allows you and your employer to contribute to a traditional IRA. Generally, these are used by small employers that don’t offer a 401(k) or 403(b). The most an employee can contribute to a SIMPLE IRA is $16,000 (those over age 50 can make an additional catch-up contribution of $3,500. 
• SEP IRA: A SEP IRA is a simplified employee pension where employers can make tax-deductible contributions for eligible employees. Employees cannot contribute to these accounts, but you can open your own IRA even if you have a SEP IRA from your employer. Annual contributions are limited to the lesser of a) 25% of the employees compensation or b) $69,000.

Many investors will have multiple retirement investment accounts, pairing an employer-sponsored plan like a 401(k) with an individual retirement account like a Roth IRA to take advantage of the different benefits offered by each. 

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Step 5. Put together an investment plan

Once you have your retirement account(s) and start making contributions, it’s time to choose your actual investments. Think of an account as your investing vehicle, not an investment in and of itself. You still need to determine the right mix of investments for you and build your portfolio. There are many retirement investing options and the rules about which assets you can hold vary among types of retirement accounts. 

So what kinds of investments belong in your retirement portfolio? Many people invest more aggressively when they’re young and slowly shift to a more conservative approach as they get closer to retirement. When you have decades before you retire, your investments still have a lot of time to bounce back from market turbulence, so you might go for higher-risk options with potentially higher rewards, such as stocks. But when you’re close to retirement, a bad year could have a much bigger impact on your plan, so less volatile securities like bonds might be more appealing.

Diversification is a strategy you might consider to spread your investments around. Diversification involves investing in both stocks and bonds, allowing exposure to the growth potential in stocks while balancing risk with the stability of bonds.

Revisit your plan as things change

 Investing would be much easier if we could see the future. Since we can’t, we have to work with our current knowledge and update our plans along the way. As you go through major life changes like getting married, having kids, owning or selling businesses, buying or selling homes, etc., you may want to revisit your retirement plan and make adjustments. 

Similarly, you’ll want to check in on your portfolio periodically (semi-annually or annually) to rebalance or adjust your mix of investments to accommodate changes in the market, if necessary. If you’re confident in your investing knowledge, you might manage your portfolio yourself. But you can also seek investing advice from several sources, including a robo-advisor or a human financial advisor.

It’s never too late or early to get started

The best time to start investing is yesterday; the second best is today. The longer your money is invested, the more it can grow through the power of compounding.  

Regardless of your age, you can start investing for your future now. Stash Retire gives you access to automated, zero-commission Roth and traditional IRA accounts so you can start taking control of your tomorrow, today. 

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The Financial Independence, Retire Early (FIRE) movement is a philosophy dedicated to aggressive budgeting, extreme saving, investing, and retirement planning. The goal is to achieve financial freedom that allows you to retire far earlier than traditional savings methods would allow. 

In this article, we’ll cover:

• What the FIRE movement is
• How  the FIRE movement works
• Common FIRE movement philosophies
• Who the FIRE movement attracts
• Tips for participating in the FIRE movement

What is the FIRE movement?

FIRE stands for Financial Independence, Retire Early. The goal is to save up enough money so you no longer need to work and to do so much younger than the traditional retirement age of 65. Financial independence is achieved when you can cover all your living expenses with your savings and investment income so that you can retire early.

Exactly who started the FIRE movement is unclear, but many of the concepts underlying it come from Your Money or Your Life, a 1992 book by Vicki Robin and Joe Dominguez. The book’s core premise is that people should evaluate their expenses in relation to the number of working hours it took to pay for them. For example, if you want to buy shoes that cost $100, and you make $25 an hour, are those shoes worth working for four hours of your life?

FIRE is a long-term strategy that involves maximizing income, reducing costs, and aggressive saving and investing. There are three common kinds of FIRE strategies to choose from. 

• Fat FIRE: Those attempting Fat FIRE want to retire early but maintain their current standard of living. This requires substantial savings, heavy investing, and generally a high income, as the focus is more on maximizing income and investment returns than reducing expenses.
• Lean FIRE: Lean FIRE is the opposite of Fat FIRE, and is the more traditional FIRE strategy. When you Lean FIRE, you’re willing to pursue a minimalistic lifestyle in order to retire early. Some people will live on as little as $25,000 per year, even if their income is many times more than that.
• Barista FIRE: This approach balances the techniques of Fat FIRE and Lean FIRE. These individuals are willing to “partially retire,” quitting their full-time job and supplementing their retirement with part-time work or passive income in order to live below their means without committing to an extremely frugal lifestyle. 

How does the FIRE movement work? 

There are three major elements to any FIRE strategy: reducing expenses, increasing income, and investing as much money as you can in a mix of taxable and tax-advantaged accounts. 

To achieve financial independence and retire early, you’ll need to understand how much you need to retire, actively manage your current lifestyle and expenses, and stick to a strict savings and investing strategy. 

• Thorough planning: The FIRE movement stresses the importance of having a detailed financial plan and sticking to it long-term. That requires close attention to personal finances, including detailed retirement planning and precise budgeting for how every penny is spent, saved, and invested. 
• Financial discipline: The goal is to maximize the money coming in, minimize the money going out, and optimize where your money is stored and invested. You can’t casually participate in the FIRE movement; it requires consistency and discipline. That said, you can use a lot of the FIRE concepts to improve your own financial situation, even if you aren’t following the philosophy to the letter.
• Dedicated investing: Investing is at the core of retirement planning. But when you pursue FIRE, you can’t rely solely on traditional retirement strategies. Retirement accounts like 401(k)s and traditional and Roth IRAs come with steep penalties for withdrawing money before age 59½, and you can’t start drawing social security until age 62. So FIRE followers need a taxable brokerage account that can provide income when they retire early. FIRE followers also have to invest a larger portion of their income than is traditionally recommended in order to retire more quickly. 

Core FIRE movement techniques

FIRE followers have put together a handful of specific strategies for achieving the level of financial independence needed for early retirement. 

The rule of 25

If you want to retire early, you need to know how much money you need to live after you stop working. The rule of 25 states that you’ll need to save up 25 times of your annual expenses before you retire. You can calculate this number for yourself by estimating your monthly expenses, multiplying them by 12 to get your annual expenses, and then multiplying that number by 25. 

Here’s an example:

• Monthly expenses = $5,000
• Annual expenses = $5,000 x 12 = $60,000
• FIRE number = $60,000 x 25 = $1.5 million

The rule of 25 provides the key financial goal for the FIRE method: the amount of money you have to save up before you can retire. Of course, the rule makes several assumptions, so think of it as a goalpost for planning instead of a fixed number. This rule doesn’t account for inflation or significant lifestyle changes, like new chronic illnesses or substantial changes in annual costs. It’s also designed to cover 30 years of retirement. Depending on how early you plan to retire and how circumstances change over time, you may need to adjust your target number.  

The 4% rule

The 4% rule states that retirees can withdraw 4 percent from their savings and investment accounts every year in order to have enough money to live on for 30 years. This means withdrawing 4 percent in year one and then adjusting for inflation in subsequent years. 

For example:

• Value of savings and investments: $1.5 million
• Annual withdrawal in year one: 1,500,000 x .04 = $60,000
• Annual withdrawal in year two (assuming 2% inflation): $60,000 x 1.02 = $61,200 

The 4% rule is designed to be general. So, when building your personal FIRE strategy, test out a couple of variations to see what might work for you. Maybe you need closer to 5% to 6% or can get away with as low as 3.5% depending on the lifestyle you plan to have in retirement. 

The power of compounding growth

Compounding is when your interest and returns from one period earn additional interest and returns in subsequent periods. Essentially, it’s a percentage of money you gain on top of what your principal investment earns. Compounding can be a powerful tool to get you closer to early retirement and financial freedom. 

The power of compounding relies on long-term savings and investments. Interest on savings, dividend income from stocks, and returns on investments must stay invested in order to earn additional returns. The sooner you start investing, the longer your money has to grow and compound. 

Tax efficiency

Traditional retirement accounts come with tax advantages that help you keep more of your money instead of spending it on taxes. But if you withdraw money before you’re 59½, you lose those advantages and have to pay penalties. FIRE followers often seek to retire much earlier than that, so they diversify where they invest so they can reap tax benefits while also generating enough income to cover their expenses between early retirement and traditional retirement age.  

• Tax-advantaged retirement accounts: IRAs and 401(k)s can help lower your taxable income and allow for tax-deferred or tax-free growth on investments as long as you don’t withdraw money early. FIRE investors often leverage these accounts to save for their retirement expenses after age 59½, while planning to withdraw from their brokerage account after they retire but before they hit that milestone.
• Health savings accounts (HSAs): Healthcare expenses are an important consideration in planning for your later years, and HSAs can provide significant tax savings on money you spend on qualified medical expenses. First, you fund the HSA with pre-tax money, reducing your taxable income each year you contribute. Second, you don’t have to pay taxes on money you withdraw from the account as long as you spend it on qualified healthcare expenses. And finally, the funds in your HSA can be invested, and earnings are not taxed if they’re spent on qualified medical expenses. 
• Tax-efficient investments in brokerage accounts: While a brokerage account doesn’t offer any particular tax advantages, FIRE investors can look for tax-efficient options. Holding investments for more than a year generally lets you pay the lower long-term capital gains rate on returns, as does earning qualified dividends. Index funds, exchange-traded funds (ETFs), and some mutual funds may also be more tax-efficient because they might trigger fewer capital gains. 

Who is the FIRE movement for?

People who follow the FIRE movement would rather live frugally and be very disciplined about their personal finances so they have more years of their lives free from the obligation to work. FIRE followers often forgo living in high-cost areas, owning new cars, taking vacations, dining out, and spending on entertainment to accomplish this goal. 

Each individual has their own definition of early retirement; some people see age 55 or 50 as attainable, while others aspire to leave the workforce much younger. Regardless of the specific goal, anyone who can live well below their means to reach financial independence can follow the principles of the FIRE movement. For a real-life example, check out the story of one couple who used the FIRE movement to pay off $200k of debt and move toward financial independence.  

Limitations of the FIRE movement

While anyone can technically pursue financial independence and early retirement, it can be a difficult path, and there are a number of barriers that can make achieving FIRE more difficult. These include financial burdens beyond one’s control, like extensive or chronic healthcare needs, familial obligations, high student loan debt, and unpredictable life events and emergencies. Additionally, pursuing FIRE can require a high income that may be more difficult to obtain for those coming from historically oppressed populations, lower socioeconomic backgrounds, or those who face barriers working traditional jobs. 

In reality, FIRE isn’t necessarily attainable for everyone. That said, even those who can’t commit fully to a FIRE method can use elements of the philosophy to improve their overall financial situation. 

Tips for participating in the FIRE movement

• Create and stick to a budget: Building a budget that includes detailed plans for spending, saving, and investing is fundamental for following the FIRE method. If you already have a budget, you might need to heavily rework it or start from scratch to make sure you’re allocating enough money each month toward your retirement goals, debt repayment plans, emergency fund, and other financial goals. 
• Determine your retirement needs: If you want to retire early, you’ll need to plan meticulously. Start by understanding when you want to retire and how much money you’ll need. Then you can work backward, using the rule of 25 and the 4% rule to determine what income and savings rate you need. A retirement calculator can help you zero in on those numbers based on your individual goals and circumstances.
• Save or invest 50% to 70% of your income: To successfully FIRE, you’ll need to save and invest as much as you can. The usual rule of thumb is to save 20% of every paycheck, but those participating in the FIRE movement usually aim for 50-70% of their income instead.
• Pay off your mortgage: You can dramatically reduce your post-retirement expenses by paying off your mortgage early. This has the dual advantage of reducing how much you pay in interest on your mortgage overall and reducing your monthly post-retirement expenses by eliminating a mortgage payment from your budget. 
• Minimize expenses and spending: FIRE is a long-term goal, and requires significantly trimming short-term spending. To successfully FIRE, you’ll need to reduce your expenses and save as much money as possible. You’ll also need to track expenses carefully to ensure you don’t derail your plans. Many people use cash or a debit card instead of a credit card to help curb the potential for overspending.
• Get out of debt: Debt can quickly douse your FIRE strategy. The sooner you get out of debt, the sooner you can start putting the money you’re spending on interest payments toward your retirement savings. Paying off high-interest debt through the avalanche method can help you spend less on interest payments overall.
• Build up your emergency fund: An emergency fund helps you avoid going into debt or draining your savings and investment accounts when unexpected expenses come up. Most experts recommend you maintain enough for three to six months of living expenses in your emergency fund. For those pursuing FIRE, it’s generally recommended to stash enough money to live on for 12 months if possible.
• Plan for medical needs: While it’s not possible to anticipate exactly what your healthcare needs will really be in the future, they’re an important factor in understanding how much money you’ll need to live on in the future. If you have known medical expenses, factor those into your FIRE strategy. Take advantage of an HSA and maintain an emergency fund to prepare for medical expenses. Remember, you don’t qualify for Medicare until you’re 65, so you’ll have to be able to cover all your medical expenses in the meantime. 
• Start investing with a brokerage account: Think of your brokerage account as a bridge to carry you from your early retirement age to 59½, when you can withdraw from tax-advantaged accounts penalty-free. Take the number of years you have between those ages and multiply it by the annual retirement income withdrawal you determined using the 4% rule. For example, say you want to retire when you’re 54½ and will need $60,000 a year to live on. Since you’d need to draw from your brokerage account for five years, you’d need about $300,000 in that account. 
• Contribute to tax-advantaged retirement accounts: You can have multiple tax-advantaged retirement accounts, so explore all your options. Traditional and Roth IRAs have different tax advantages; you might leverage one or both to get the most tax benefits. If your employer offers a 401(k) plan, you might want to take advantage of it as well, as it comes with an entirely different set of benefits and limitations compared to IRAs. 
• Diversify your investments: To ensure your investments will carry you through retirement, you’ll want to reduce risk by diversifying your portfolio. This means spreading your holdings across different asset classes so major changes in one company or sector don’t have as significant an impact on the overall value of your investment portfolio.

How to make the FIRE movement work for you

FIRE isn’t for everyone, but its philosophies can benefit even those who don’t want to commit to the movement fully. The core concepts of decreasing expenses in order to save and invest can help anyone improve their personal finances and work toward a greater sense of financial freedom. 

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You want to be better with money but don’t know where to start. This year, with high inflation, the return of student loan repayments, and global uncertainty—perhaps your finances have paid the price. 

All that to say: Improving the bottom line has never been harder for hardworking Americans.

So in service of helping you get on track, Stash collected 100 of the best financial tips you’ll want to implement going into 2024—advice that will lessen the burden on your wallet and make it possible for you to get closer to your money goals.

Our Stash 100 tips are simple, jargon-free, and easy to follow. Bookmark them, share with your friends, and scrawl them on your mirror. It’s advice that will lessen the burden on your wallet and, even more importantly, put your mind at ease as you tackle the world ahead.

Investing 

1. Invest now. The sooner you start investing, the greater your earning potential.

2. Invest for the long-term with a buy-and-hold approach, and put your money to work. 

3. Invest regularly, and it becomes a powerful new habit that compounds your success. 

4. Diversify. Choose a variety of investments with different risks to reduce your risk of loss and reduce swings in your account value.

5. Choose low-fee ETFs. It’s safer to invest in ETFs, or baskets of assets, than in any one asset. 

6. Take advantage of dollar-cost averaging, which is periodically buying certain stocks or other assets using a set amount of money on a schedule. You’ll buy assets when the price is low and when it’s high without being driven by emotion. 

7. Combat inflation by investing your cash. Keeping too much money on-hand allows inflation to erode its value over time.

8. Don’t be afraid to invest. Having some cash is important, but keeping all your money on the sidelines can put you at risk for missing out on tens of thousands, or even millions of dollars over the course of your lifetime.

9. Keep your emotions in check. Avoid impulsive decisions based on fear or greed, and instead focus on your long-term goals and intentions. 

10. Don’t panic sell just because an investment is down. Knee-jerk reactions can derail your investing success.

11. Leave day-trading behind. You can be a great investor without being a frequent trader. In fact, trading less often can often be a better investment strategy. 

12. Focus on goals. Understand your objectives and time horizon to help you determine what combination of investments is right for you.

13. Park your cash in short-term Treasurys if you think you will use it within a year. 

14. Learn the value of compound interest, or when interest earns interest because it remains invested. It allows your money to grow exponentially over time. 

15. Avoid concentration risk. Buying individual stocks can be fun, but you shouldn’t invest more than 2% of your portfolio in any one stock.  

16. Automate your investments. Then check in at least once a year or when you have a major life change to make sure your investing strategy still makes sense for you. 

17. Understand and minimize what fees you are paying on your investments. Compare similar funds’ expense ratios and look out for commissions and other hidden fees. 

18. Don’t trust anyone that tells you they know how the market or a stock will perform in the future. No one has a crystal ball. 

19. Remember that investing is a marathon, not a sprint. Get-rich-quick schemes often end up in losses.

Retirement Planning 

20. Save for retirement. The years pass faster than you expect.

21. Start by saving 1% of your salary if that’s all you can afford now, and work your way up in 1% increments. Saving for retirement may feel like a luxury or impossibility, but any amount of savings is better than none. 

22. Use standard guidelines for retirement planning: Consider setting aside 15% of your pre-tax salary for retirement if you want to retire in your 60s and maintain your lifestyle. 

23. Calculate a personal retirement goal. If you aren’t sure, retirees typically spend between 70-80% of their pre-retirement income to maintain a similar lifestyle. You can also multiply how much you think you’ll spend every year of retirement by 25, and start there. 

24. Does your employer offer a retirement plan? Evaluate the investment options because every plan is different. Then choose one that’s appropriate for you, and never let your contributions sit idle. 

25. Don’t leave money on the table. Prioritize taking advantage of any employer match offered in your retirement plan. 

26. Consider multiple accounts. If you’re eligible for an employer-sponsored plan like a 401(k) and an individual retirement account like a traditional or Roth IRA, you may want to take advantage of both simultaneously—they each have their own pros and cons. 

27. Add social security benefits into your calculations by checking your Social Security Statement at SSA.gov. Guaranteed monthly income in retirement can help you maintain your retirement nest egg much longer.   

28. Healthcare related costs are retirees’ largest annual expense. Consider investing in a Health Savings Account (HSA) if you have access to a high deductible health plan. They have great tax benefits and will help offset those large expenses in your golden years. 

29. Try to avoid touching your retirement accounts, and learn about the tax implications and penalties associated with different retirement account withdrawals. Retirement funds are generally only accessible without penalty after you turn 59.5. 

30. Plan to retire early? Understand the tax rules and penalties of accessing your investments, and consider having alternate investment accounts that you can withdraw from first if need be.   

31. Avoid cashing out your retirement plan when changing jobs (it’s called an early distribution), which can tack on taxes and fees. Roll that money into an IRA or your new company’s 401(k) plan and allow the money to continue to grow. 

Financial Wellness 

32. Honor the principles of saving and investing. It’s not about how much you make—you can make a million dollars a year and still be flat broke if you spend it all. 

33. Set SMART savings goals. Make goals Specific, Measurable, Achievable, Realistic & Timely. This will help keep you motivated and aware of your progress.  

34. Establish an emergency fund as priority one. A good rule of thumb is to save between 3-6 months worth of your essential expenses. 

35. Eliminate stress over your bills by setting up automatic payments. 

36. Avoid the pitfalls of the U.S. post office by opting for direct electronic payments.  

37. Save money by changing banks. You may reduce expenses like monthly fees by switching banks or using an online financial institution for your checking and savings accounts.

38. Earn money on your cash. Set aside what you need for regular spending, then maximize the interest you earn on excess cash by comparing high yield savings accounts, money market funds, and U.S. Treasurys. 

39. Pay yourself first. Sometimes an employer can deposit a percentage of your paycheck directly into your savings or investment account, or set up an automatic transfer for when your paycheck hits. 

40. Check your pay stub regularly. Ensure that deductions are accurate and tax withholding seems appropriate. Consult HR right away if something seems off.

41. Protect what you have. Insurance is an often overlooked part of financial health. Whether it’s adequate health insurance, car insurance, homeowners, life or disability, set yourself up for unexpected life events.

42. Jumpstart your child’s long-term savings with a custodial account.

43. Talk to your kids about money. Teaching financial skills such as budgeting at a young age can help lead to strong financial habits as they grow. Celebrate milestones together to model diligence. 

44. Acknowledge your hard work when you hit a savings balance or come in under budget. It’ll keep you motivated for future success.  

45. Take security seriously. Use strong passwords, two-factor verification, and secure internet connections when managing your finances online. 

46. Be vigilant about phishing scams, especially approaching the holiday season when fraud activity tends to increase. It can be very hard, if not impossible, to get stolen money back.

Budgeting

47. Create a budget to help you understand where your money goes every month. One way to do it: Take the money that hits your bank account, minus your expenses, equals what’s available for your goals. 

48. Keep budgeting simple with the 80/20 approach: Save 20% of what you make so you limit the rest of your spending to 80% of your income. You can also get even more detailed with the 50/30/20 rule.

49. Keep a money journal and track all of your expenses—but don’t let it overwhelm you. The goal is to build awareness of your spending habits.

50. Create funds for large and irregular expenses like the holidays, travel, camp, or car maintenance. Set aside money each paycheck or month so that the money is available when you want it.

51. If taxes aren’t automatically deducted from your paycheck, set aside part of your paycheck so you don’t find yourself in trouble come filing season. 25-35% is a good starting point (refer to last year’s taxes or speak with your accountant for a more precise estimate).

52. Make a shopping list in advance—and stick to it! Studies show you can save yourself from unplanned purchases when you have it in-hand. 

53. Overspending? Try the 30-day rule. If you want to make an unplanned purchase, set the money aside for 30 days, then revisit. Often you’ll find the impulse to spend has gone away and you’re able to avoid unnecessary purchases. If waiting 30-days feels unrealistic, start with 48 hours. 

54. Delete your online payment info. The more effort it takes to shop online, the more likely you’ll be to pause and think about whether you truly want to buy it.

55. Sometimes it’s the right time for a “cash diet.” Commit to only making purchases in cash. You’ll likely spend less even on planned purchases like groceries, and it guarantees you won’t spend more than you’ve budgeted.

56. Swap your credit card for a debit card: Research shows that consumers spend less when they see real money immediately leaving their bank account. Pay down your credit card more frequently for a similar effect. 

57. Buy store brands instead of name-brand products with the same ingredients. Tiny savings add up on frequent purchases. 

58. Beware of BOGO “deals.” Slow down and consider the price of one item; often they are marked up to cover the cost of the discount. 

59. The best rates on hotels sometimes come 15 days before you travel. Make a refundable reservation far in advance, and then check the rates again leading up to your trip. If rates have dropped, cancel the original booking for free and lock in the lower rate. 

Debt

60. Take inventory. Make a list of your debts, such as credit card bills, student and auto loans, and mortgages, and include the lender, balance, interest rate, payment date, and monthly payment amount. Then take action.

61. Consider using the debt snowball or avalanche methods to prioritize which debt to pay down first. Each approach targets focusing on one debt at a time, rather than making extra payments on multiple obligations each month. 

62. Try to avoid paying more in interest and fees. While consolidating debt can be a smart solution, doing so in a high interest rate environment might mean more dollars out of pocket now. Beware of committing to a higher minimum monthly payment if cash flow is tight.

63. Pay off your high interest rate debt—such as credit card debt—first. You’ll save more by paying off credit card balances than you can realistically expect by investing those dollars in the stock market instead. A credit card balance can also bring down your credit score.

64. Take advantage of debt that works in your favor. Low-interest, installment loans like mortgages (especially those that are fixed and below 5%) and auto loans can help you build credit. 

65. Don’t pay more than the minimum required for low-interest, fixed-rate loans. If your fixed rate loan is low enough, invest the extra dollars for a higher return. 

66. Pay extra attention to variable interest rates to avoid fluctuating payments that are out of your control. 

67. Considering a new debt? Practice paying for it. Set aside a monthly payment for a few months for insight into how a new financial expense will impact your finances. 

68. A car payment doesn’t have to be an indefinite expense. Try to keep a 60 month loan or less, and continue to drive the car once it’s paid off. 

69. Zero-percent interest car loans may mean the car price itself is marked up or there’s some other catch. 

70. Beware of credit card rewards. Avoid spending more than you would typically spend just for the rewards. Buy the perk with cash—save your bottom line.

71. Refinance. When your credit score goes up or your cash flow improves, you may be eligible for a better rate on your existing loans. Run the numbers to see if it makes sense—this strategy may have upfront costs but could lower your monthly payments.

Credit

72. Not sure how to build good credit? You’re not alone. Consider using a secured credit card, which requires payment upfront. Make sure to understand the fees.

73. Lean on family or friends to build your credit. Asking someone with strong credit to cosign for you can help you obtain a better rate, or faster approval, than what you may be able to secure on your own. 

74. Build better credit in a short amount of time when you are added as an authorized user on someone else’s account. Note: Credit scores become intertwined, and both can be negatively impacted if someone doesn’t pay the bill on time. 

75. Take good care of your credit to be eligible for loans with more favorable rates. Pay bills on time and keep your outstanding balances low compared with your limits (this metric is called credit utilization). 

76. Remember that your credit score isn’t private. Think of it as a financial report card that can be shared with future employers, landlords, and lenders. 

77. When you open a credit card, use it responsibly. Charge at least one expense per month, like gas, and pay it off in full if possible. Then continue to pay it off in full every month. 

78. Carrying debt does not benefit your credit. Credit card interest compounds daily, working against you because the debt adds up rapidly. 

79.Set a reminder to check your credit report for free once a year with these three credit bureaus: Experian, Equifax, and Transunion. Or check annualcreditreport.com, which is a one-stop-shop. 

80. Dispute credit report errors. If there’s any incorrect information, contact the credit bureau directly.

81. Ask for a credit line increase. A good repayment history, higher income and/or higher credit score can warrant an increase. A higher limit can help your credit too, as long as you don’t spend more and raise your average balance. 

Homebuying/Home ownership 

82. Renting may be smarter—most homebuyers don’t break even for five years. If you expect to move sooner, consider renting instead.

83. When thinking about home-buying, cap your housing costs. Target a total monthly payment of no more than 28% of your gross monthly income towards a home. This should include principal, interest, taxes and insurance (PITI). 

84. Know what you have available for a down payment, and what you can afford monthly for your mortgage. Keep both in mind when trying to determine your price range. 

85. Negotiate your interest rate, and shop around. The process can be tedious, but every point negotiated down on your mortgage can be a huge cost savings. 

86. Do your research before making an offer. One tried and true way to value a home is looking at “comps,” which are comparable homes in the area that recently sold.

87. Understand PMI. Private mortgage insurance is an additional monthly cost assessed by a lender in the event you put less than 20% down. It may not be a reason to wait until you can afford more, but you’ll want to budget for the extra monthly cost, which is usually 0.5–1.5% of the cost of the mortgage each year.

88. Don’t overlook closing costs, which usually range between 3-5% of the purchase price. Example: if you want to make a 10% down payment, you’ll need between 13-15% of the purchase price in cash to complete the transaction. For a more exact estimate use a closing cost calculator specific to your state. Don’t forget moving costs.

89. Get pre-qualified and include it in your offer. Obtaining pre-qualification (not to be confused with pre-approval) can start the process of determining what you can afford, and it should not impact your credit or require underwriting. 

90. Build a home emergency fund for the things you need to repair and replace, ongoing costs, and one-time costs, too. Plan for overages when setting a budget for home renovations. 

Taxes

91. Keep track of deductible expenses throughout the year to maximize your tax deductions, especially if you’re self-employed. A standard deduction is applicable to everyone; other deductions—like large medical expenses and charitable donations—are relevant only if you decide to itemize your deductions. 

92. Know the tax implications of different retirement accounts. Investing into a traditional 401k or IRA can reduce your current taxes, which saves you money now, but in retirement, you’ll have to pay taxes on your withdrawals. Compare that to a Roth 401k or IRA, which won’t reduce your current taxes, but investments will grow tax free and you’ll save on taxes in the future.

93. Consider investing into a 529 plan for your children’s education. In some states, 529 plan contributions are tax-deductible and your investments grow tax-free.

94. Save on childcare. If you have kids and pay for daycare or camps, save on your taxes by contributing to a Dependent Care Flexible Spending Account (DCFSA.) Money is added directly through your paycheck pre-tax and can be used to reimburse you for your childcare related costs.

95. Self employed and/or experience a major life event? Tax professionals are a worthy investment. Not only can they make sure you file your taxes accurately, they can also help you make strategic money decisions throughout the year. Make sure their expertise is relevant to your situation. 

96. A large tax refund isn’t necessarily something to celebrate, as it typically means you overpaid the government during the year. Think of it as an interest-free loan to the government—not the prize you’re hoping for. 

97. Getting a tax refund year after year after year? Adjust your tax withholdings with your employer to keep more of it each paycheck. 

98. Use tax software to simplify the filing process. Depending on your income, you may be able to use some services at no cost. Find more information at irs.gov.

99. Keep copies of your tax returns for reference (digital is okay!). Up to seven years is suggested if you worry about being audited. Lenders typically only ask for a two-year history when applying for a loan.   

100. Make tax filing easier. Create a physical or digital folder and collect all tax related documents over the course of the year and you’ll stress less in spring. 

BONUS: Holiday

101. Set and stick to a holiday season budget. In addition to gifts, include travel and transportation, new clothes, holiday bonuses, decorations, and fun activities (like ice-skating). Be specific. 

102. Make a list of gift recipients and a spending limit per person.

103. Shop early. You’ll avoid rush delivery costs and needing to search for last-minute, expensive alternatives.

104. Book travel as soon as you can and be flexible with your schedule for better deals. 

105. Hosting doesn’t have to be expensive. Price shop and avoid recipes with too many new ingredients. Consider a pot-luck option instead of trying to do it all yourself.

106. Shop online. You’ll avoid impulse purchases, and it’s easier to search for discounts and price comparisons. Many online retailers offer free shipping during the season. 

107. Get creative. Thoughtful gift giving doesn’t have to cost you a lot of money. You can make gifts, like art, a note or baked goods, or you can gift time by offering to babysit/pet sit or help someone with other household chores. 

108. Suggest a gift exchange. Suggest a white elephant or secret santa so everyone only needs to buy one gift that will likely be more thoughtful and exciting to receive. 

109. Avoid (or limit) self-gifting. Retailers will be bombarding you with “deals.” Resist sales and unneeded purchases. Unsubscribing works wonders.

110. Celebrate late. Consider doing your holiday gatherings a few weeks later, allowing you to book less expensive travel and buy up gifts at post-holiday sales. 

111. Be selective. You don’t have to say ‘yes’ to every invitation, or include everyone on your guest list. Keep gatherings intimate, and choose only the events you want to attend most when choosing how to allocate your dollars.  

112.  Reflect and evaluate what worked this holiday season, then eye January as an amazing time to commit to new financial goals. 

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The post The Stash 100: Money tips everyone needs to know  appeared first on Stash Learn.

If you’re new to investing, compounding should be at the start of any investing discussion. Compounding refers to earning interest on top of the interest you’ve already accumulated from previous periods, and it’s a way to potentially magnify your savings over time just by staying invested in the market.

If you can understand compounding as a beginner, it allows you to get excited about the possibilities of investing and set expectations about how that money can grow over time.

So, what is compounding?

Simply put, compounding is the percentage of money you earn on top of your original investment (aka your principal investment) plus its earnings from previous periods. It can be calculated by banks or financial institutions on a daily, monthly, or annual basis. 

How does compound interest work?

Compounding interest is the interest on a loan or investment found by the initial principal plus the interest accrued from preceding periods. 

The principal is compounded because it’s periodically increased by a percentage (i.e., adding 10% each month). This differs from linear growth when the principal is increased by a fixed number (i.e., adding 10 each month). Let’s look at an example: 

Imagine that you deposited $100 in a savings account that accrues 10% interest annually. After one year, you’d have $110 in that savings account. After two years, though, your interest would have compounded, and you’d have $121.

That’s because you’re not just earning 10% interest on your initial deposit ($100)—you’re earning interest based on your new total earnings ($110). So after two years, you’ll earn your 10% interest based on your new total of $110. Here’s a breakdown of how those earnings could compound over time: 

Initial deposit: $100

Year 1: $100 + (100 x 10%) = $110

Year 2: $110 + (110 x 10%) = $121

Year 3: $121 + (121 x 10%) = $133

And after 10 years of compounding at a rate of 10%, your $100 deposit would grow to $259.37. That’s the power of compounding in action.

So, what does compounding have to do with you and your money? 

Compounding can either work for you or against you, depending on whether it’s for an asset or a liability. The example above shows how compounding works in your favor if it’s for a savings deposit or investment (assets). 

But it can also apply to liabilities, like money owed on a loan—when compounding interest is accrued based on your unpaid principal plus interest charged over time. In this case, the compounding interest means the amount you owe increases (compounds) over time. Compounding money when it comes to accounts with debt is something you want to avoid. 

The compound interest formula

The formula to calculate compound interest is A=P(1+r/n)nt.

• A = the total amount of money accrued on your principal plus interest, after n years 
• P = principal (the initial investment or deposit) 
• r = interest rate (in decimal form) 
• n = number of compounding periods (how often the interest is compounded per year) 
• t = time in years (how long the principal remains invested/deposited)  

Let’s put this formula into action with some concrete numbers. Say you deposit $500 into a savings account with a 5% interest rate that compounds monthly for 10 years. So: 

• P = $500 
• r = 0.05 
• n = 12
• t = 10

Now let’s plug those numbers into the compound interest formula: 

A = P (1 + [r / n]) ^ nt

• A = $500 (1 + [0.05 / 12]) ^ (12 * 10)
• A = $500 (1.00417) ^ (120)
• A = $500 (1.64767)
• A = $823.84

In 10 years, your new total is $823.84—your principal plus $323.84 in interest. 

Compound interest vs. simple interest

Simple interest is interest that’s paid only on the initial principal of a loan, and not on any interest from previous periods. That means the interest isn’t compounded. 

Going back to our $500 savings deposit example, a deposit of $500 with a 5% interest rate would mean earning $25 a year, every year. Instead of the earned interest being added back into the principal (compound interest), simple interest is calculated based on the original principal alone.  

Here’s how to calculate simple interest: 

A = P (1 + rt) 

• A = the total amount of money accrued after n years, including interest
• P = principal (the initial investment or deposit) 
• r = interest rate (in decimal form) 
• t = time in years (how long the principal remains invested/deposited)  

We can see that this formula is just a simplified version of the compound interest formula. Here’s what it looks like using our $500 example: 

A = P (1 + rt) 

• A = $500 (1 + [0.05 * 10]) 
• A = $500 (1 + 0.5) 
• A = $500 (1.5)
• A = $750

Ten years of earning 5% simple interest on your $500 deposit yields an extra $250 earned. 

Compound returns

The answer to “what is compounding” is incomplete until we also understand the element of compound returns.  The magic of compounding is revealed when it comes to compound returns on your investments in the market. 

When you keep reinvesting the dividends you earn, your returns have the chance to compound significantly over time. And if you’re a young investor who still has a ways to go until retirement, your opportunity to accumulate long-term wealth grows exponentially. 

Timing is everything when it comes to compounding. The sooner you start investing, the more time that money has to grow. Even a small amount a day can add up to sizable returns thanks to the power of compounding. Here’s a brain teaser to prove it: 

If you were offered the choice of $100,000 today, or a penny today with the amount you receive doubled every day for a month (a penny on the first day, 2 cents on the second day, 4 cents on the third day, etc.), which would you choose?

Surprisingly, it’s smarter to start with the penny, because by day 31, you’d have more than $10 million. That’s the magic of compounding. 

Examples of compounding

As we mentioned earlier, compound interest can work for you or against you, depending on whether you’re investing money or owing money. Here are some  examples of compounding in different types of accounts: 

• Savings and checking accounts: Making deposits into an interest-bearing account like a savings account means that interest will be added to your balance, allowing your money to grow over time. 
• Tax-advantaged retirement accounts (401(k)s and Roth IRAs): Investments in accounts like a 401(k) or a Roth IRA also compound over time, and you can grow your balance faster if dividends are reinvested regularly. 
• Student loans, mortgages, and other personal loans: Compound interest works against you when you’re borrowing money. Compounding on loans means any unpaid interest for a given period is added to your loan balance, from which future interest charges are accrued. 

Best practices for approaching compound interest

Any new investor should apply the power of compounding if their goal is to accumulate long-term wealth. Use these tips to reap the full benefits of compound interest and allow your money to work for you: 

• Start early: The sooner you start investing, the longer your money has to grow. Every day you wait is a missed opportunity to benefit from the power of compounding. 
• Pay off debt: Since compounding works against you when you’re borrowing money, prioritize paying down any debts to avoid paying more over time. 
• Focus on the long term: Time is on your side when it comes to compound interest. Instead of going after short-term gains or cashing out when the market is high, learn to ride the waves of the market and give your money time to grow. 

• Look at APY, not APR: Focus on annual percentage yield (APY) rather than APR when comparing accounts. The APY provides a more accurate view of expected interest earnings, whereas APR accounts only for the simple interest rate. 
• Choose accounts that compound interest daily: Compounding frequency is the interval at which your interest is paid out. The more often interest is paid, the greater returns you’ll see from compound interest—look for accounts that compound daily rather than quarterly or annually. 

The concept of compounding reveals why investing can be a smarter path to building wealth than simply saving. Not to mention, one of the keys to maximizing your financial potential is to save or invest money early and often.

If you’re looking for extra support, consider turning to a platform like Stash—users can automate the investing process with the help of Auto-Invest, which can save or invest money for you automatically.

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Compounding FAQs

Have more questions along the lines of “what is compounding?” We have answers.

What is the rule of 72?

The Rule of 72 is a calculation that estimates how long it would take for an investment to double in value as a result of compound interest. Here’s the formula:

Years to double = 72 / rate of return on investment (the interest rate) 

In other words, you can find the number of years it would take to double an investment by dividing 72 by the interest rate. 

How can investors receive compounding returns? 

Investors can receive compound returns through dividend payments. If you’re investing in stocks and the value of a stock grows over time, you can earn compound interest by reinvesting your profits. 

If payouts are made in cash, they will need to be manually reinvested in order to potentially earn additional compounding returns. Mutual funds, on the other hand, often offer automatic dividend reinvestments in order to earn compound returns.  

What type of average is best suited for compounding?

For investments that have compounding, the time-weighted rate of return (TWR)—also known as the geometric average—is best suited for calculating average returns. It’s able to provide a more accurate estimate of returns by isolating returns that were affected by cash flow changes, balancing out the distortion of these growth rates. 

The post What Is Compounding? An Explanation of Compound Interest appeared first on Stash Learn.

Your retirement savings goal may sound simple: save enough money to retire comfortably when you no longer receive a regular paycheck. But determining exactly how much money you need for retirement, and how much you should have tucked away now to be on track, can be a bit more complicated. 

Understanding the benchmarks of average savings at various stages of life is like having a compass guiding you through the complex landscape of retirement planning. It enables you to assess your own financial standing within the context of your age group.

Keep in mind that how you plan for your retirement will depend on many factors unique to your situation, so take averages with a grain of salt.

In this article, we’ll cover: 

• The average retirement savings by age
• How much you need to retire
• Retirement accounts
• Tips for saving for retirement

What is the average retirement savings by age?

Based on data from the 2019 Survey of Consumer Finances by the Federal Reserve System (the Fed), here’s the average amount people have in retirement savings based on age group.  

For added context, about 28% of non-retired adults do not have any retirement savings, according to the Fed’s 2023 Economic Well-Being of U.S. Households Report. 

How much money do you need to retire?

The average retirement savings by age may give you a benchmark for comparing your savings to other people’s, but those figures don’t necessarily reflect the recommended retirement savings by age. You’ll need to do some calculations to figure out how much money you need to retire comfortably based on your current income and the age at which you plan to retire.

Experts suggest that people need about 80% of their annual pre-retirement income to maintain their living standard after retirement. For example, if your gross income is $100,000 a year, you’ll need at least $80,000 annually to maintain that lifestyle after you retire.

You can then apply the popular 4% rule, which assumes you’ll live for 30 years after retirement and make an average 5% return on investments. The 4% rule states that you’ll want to withdraw 4% of your retirement savings annually. So, for an $80,000 annual withdrawal in retirement, you’d need savings of around $2 million when you retire ($80,000 / 0.04). 

Of course, the amount of money you need to retire depends heavily on factors unique to your life, such as the age at which you retire, your tax bracket, and your assets and debts. The annual income you’ll need in retirement is also affected by lifestyle factors like where you live, healthcare expenses, and whether you downsize to reduce your expenses.  

Remember that the money in your retirement account may not be the only source of income after you leave the workforce. You may receive social security benefits, have a pension, or earn passive income through things like rental properties. 

Finally, you may also want to think of your retirement savings goals in terms of your entire household’s needs. If you live with a spouse, partner, or partners, consider the combined income and savings of all the earners in your household, as well as any differences in how far each person is from retiring, when calculating your savings goals. 

How much of your income should you save for retirement?

Many advisors recommend you save 10-15% of your gross income for retirement starting in your 20s. If you start investing later in life or want to retire early, it may make sense to up your investments to 20% or more of your income if possible. 

Realistically, not everyone can afford to put aside that much of their paycheck. Saving as much as you can now, and increasing that amount as you’re able, can still help you work toward your goals. What matters most is that you start saving what you can as early as you can. Because retirement investing takes place over such a long period of time, your savings will be heavily impacted by compounding. The earlier you invest, the more you can earn on that money over time. 

Retirement account types

Keeping your retirement savings in a tax-advantaged retirement account can help your money grow over time. According to a 2022 report from the Fed, among those with retirement savings, 54% of non-retired adults had money in an employer-sponsored plan such as a 401(k) or 403(b), and 34% reported having money in an individual retirement account (IRA). 

Roth vs. traditional IRA retirement accounts

An IRA is a tax-advantaged retirement account. There are two primary types of IRAs, a Roth IRA and a traditional IRA, each with unique features and benefits.

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401(k) vs. IRA retirement accounts

Employer-sponsored retirement accounts, like a 401(k), offer distinct features compared to IRAs. Many employers offer a matching benefit in which they match the contributions you make to your 401(k) up to a certain percentage of your salary. 

401(k) rollovers

Because a 401(k) is employer-sponsored, you may lose some control of it when you leave your employer or risk not accounting for it in your retirement planning. Often, investors will initiate a 401(k) rollover when they leave a job, moving the money in the account into their new company’s 401(k) or rolling it into a traditional IRA. This has the benefit of giving you control over how you’re investing you money and consolidating your retirement accounts.

Tips for saving for retirement

A 2023 Gallup survey revealed that only 43% of non-retired adults expect a financially comfortable retirement, and 71% of non-retired adults are at least moderately worried about being able to fund their retirement. Not everyone knows how to start investing for their retirement or how much they should invest. 

The good news is, you don’t have to create a comprehensive financial plan or have all the answers to start putting away money for your future. Try these tips to get the ball rolling toward your goals.

• Make regular contributions to your retirement accounts. Build retirement savings into your monthly budget and put aside a bit of money from every paycheck. The slow-and-steady approach can make it less daunting to hit your goal.
• Take advantage of employer matches. If your employer matches some of your 401(k) contributions, make sure you’re contributing at least as much as they match. Your employer’s contributions are like free money to bolster your retirement savings.
• Invest extra when you can. When you get a bonus or a surprise windfall, consider putting a chunk of that money into your retirement account to give yourself a boost toward reaching your goals.
• Increase your savings when you get a raise. To avoid lifestyle creep and bolster your investments, bump up your contribution percentage when you get a raise. For instance, if you get a 3% raise, consider increasing your retirement contributions by 1%. 
• Automate your retirement investments. If you have an IRA, set up direct transfers so that your contributions are automatically taken out of your bank the same day you’re paid. That way you won’t be tempted to spend that money, and saving will feel more effortless. 
• Take advantage of different investing options. Various types of retirement accounts have different advantages, so consider investing in both a 401(k) and an IRA if you have the option. You can also invest in stocks and other securities through a brokerage account; this avenue doesn’t confer tax advantages, but it can be an additional way to build long-term wealth.
• Revisit your retirement plans annually. Did you move to a cheaper part of town? Get a new job? Buy a new house? Change marital status? As you age, your debts and assets change, which could call for adjustments to your retirement plan. 

Start working toward your retirement goals now

Are you ahead of the average retirement savings by age? Feeling behind? Whatever the case, it’s never too late or too early to start putting aside money for your golden years. 

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“How can I retire early?” That question might not keep you up at night if you’re still riding out your 20s—but if you like the idea of cutting down your working years and enjoying more financial freedom later in life, now is the time to explore your options for how to retire early. 

So what does it take to retire by the age of 55, or even 45? Knowing the average retirement savings by age can help set benchmarks for you, but the answer to how much you actually need depends on your unique circumstances and financial situation. There are a number of steps you can take if you’re serious about learning how to retire early. 

To that end, consider this your ultimate how-to-retire-early guide. In this article, we’ll cover important steps, including how to:

1. Envision your ideal lifestyle during retirement 
2. Make a draft retirement budget
3. Know your current financial standing
4. Level up your investments
5. Assess your current lifestyle for savings opportunities 
6. Identify your fixed income streams—and know how to manage them
7. Enlist the help of a financial advisor
   

Read along to learn how to retire early. 

1. Envision your ideal lifestyle during retirement

Before diving into nitty-gritty financial considerations, spend some time envisioning the type of lifestyle you want to lead in retirement. This will inform the concrete plan and budget you’ll need to support the life you envision.

Maybe you want to spend time traveling abroad or buy a vacation home. Whatever your dreams are, get clear on the cost considerations associated with each. Figuring out the best way to retire early starts with affirming your ideal lifestyle during that time. 

Be sure to consider key future life events, too. If you’re planning to move to a new state, for example, factor in cost-of-living differences for that city. Will you want to live near family or future grandchildren? Will that require you to move? Thinking about these things ahead of time will help you make more informed decisions when crafting your retirement budget.

Here are some common key life events to consider: 

• World travel 
• Starting a business post-retirement 
• Committing to volunteer work 
• Moving to a new city or state (or country!)
• Funding your kids’ or future kids’ college education
• Caring for aging parents 

2. Make a draft retirement budget

An important aspect of early retirement planning is getting specific about the projected budget you’ll need to live off when the time comes.

An easy way to do this is by creating a mock monthly retirement budget to determine how much money you’ll need to live off each month. 

Then, list your expected monthly spending. Many of your expenses will stay more or less the same in retirement, so take a look at your current costs (food, utilities, medical, insurance, internet, car, etc.) and use those numbers as a baseline.

Adjust each item as needed based on your personal retirement goals. For example, if you know you want to buy a new car for retirement, estimate the monthly payments required for the new car versus the one you currently have.

It’s also important to plan for medical expenses during retirement. Medicare eligibility doesn’t go into effect until the age of 65, no matter when you retire. Unless you know your employer allows you to keep your current health plan after retirement, you’ll need to have a plan in place for where you’ll get health insurance and how much it will cost. For many, this might mean buying private insurance, which can greatly impact your overall budget. 

3. Know your current financial standing

If your goal is to retire early, you need to take stock of where you currently stand financially and how far you have to go.

Be sure to assess the following areas when evaluating your current financial standing: 

• Emergency fund savings
• Outstanding debts 
• Mortgage payments 
• Contributions to retirement accounts (Roth IRA or 401(k))

If you’re 40 and want to retire in the next five years but only have $30,000 stashed in savings, you might struggle to have sufficient funds by the time you hope to retire.

Assessing your current financial situation provides crucial insight into the true feasibility of early retirement, revealing any adjustments you might need to make or goals you should work more aggressively toward (like paying off debt) to make it happen. 

4. Level up your investments

Once you’ve taken action on your existing long-term wealth goals—like paying off debt, having a robust emergency fund, and paying off your mortgage—you should ideally be investing at least 15% of your income for retirement.

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But if your goal is to retire early, you’ll want to find ways to put more dollars toward that goal—especially if you’re utilizing tax-advantaged retirement accounts like 401(k)s or IRAs, since those funds can’t be withdrawn until you’re 59 ½ (unless you want to pay a hefty early withdrawal fee). 

So how do you fund the gap between early retirement and when you can begin to lean on your retirement accounts? By utilizing returns from other investments! 

Once you’re contributing the maximum amount to your 401(k) or IRA, expand to other investments like exchange-traded funds (ETFs) to create a portfolio positioned for long-term growth. An ETF can passively track an existing index (like the S&P 500), making it a lower-cost option (as opposed to an actively managed mutual fund) that can compound your money over time. 

You might think that a shorter time horizon until retirement means you should make less risky investments. But remember to account for the years you’ll spend in retirement—ideally, your money will continue to grow during this time. 

When your retirement date draws near, you can plan to incrementally withdraw funds as needed, while also adjusting your risk levels down to mitigate short-term losses in periods of downturn. For example, you may allocate your taxable investments more conservatively while still contributing the maximum to your 401(k)s/IRAs. That’s because the investment funds you’ll be withdrawing—your taxable investments—are still subject to market fluctuations, so you’ll want to adjust your portfolio allocations accordingly. 

When your retirement date draws near, you may plan to cash out on a year or two’s worth of those compounded funds so you have access to more liquid savings. If this is the case, leave the remaining funds invested—simply cash out funds as needed and let the rest compound over time. 

5. Assess your current lifestyle for savings opportunities 

The earlier you retire, the longer the length of time you’ll need to fund. One of the best tips to retire early is to be honest about what sacrifices you need to make now so you can realize that goal. It all depends on how early you want to retire and what you’re willing to do now to make it happen. 

For instance, can you table your annual family vacation and invest the extra funds instead (or even just cut your vacation budget in half)? Or maybe you buy a used car in full instead of paying a monthly lease for the brand-new model you wanted.

Whether you make drastic cuts to your budget or simply stash away an extra $100 a month is up to you—just know that how much you put away now directly affects how quickly you can reach early retirement. 

6. Identify your fixed income streams—and know how to manage them

Managing your income during early retirement requires understanding how much money you have and when you can take that money out.

Your income streams are anything besides your emergency fund, such as:

• 401(k)s or IRAs
• Cash
• Dividend-paying stocks
• Real estate investment funds
• High-yield bonds 
• Any other investments you have, like ETFs or mutual funds 

If you’re retiring early, you’ll need to be strategic when it comes to planning your cash flows, since certain accounts don’t allow you to start receiving funds until you reach a certain age. The earliest you can claim Social Security benefits, for example, is age 62. And even then, you’ll only receive partial benefits, since full benefits aren’t offered until you reach age 65–67.

The rules and regulations for different accounts all vary. A financial advisor can be a valuable resource in ensuring you understand the timing and stipulations of yours. 

7. Enlist the help of a financial advisor 

While realizing your early retirement goals is ultimately in your hands, enlisting the help of a professional is a smart move. You don’t want to make a wrong move and realize you didn’t time your savings correctly or be forced to pay hefty fees because you didn’t understand the stipulations of certain accounts. A financial advisor can answer your questions and provide advice that’s in your best interest.

The answer to how to plan for early retirement is nuanced, but the steps above can expedite the process regardless of your financial standing. 

And if you’re looking for further support, an investing platform like Stash not only makes it easy to invest what you can afford, but also provides all the personalized financial education you need to move the needle on your long-term wealth goals. 

Learning how to retire early is one thing, but committing to making it happen requires some dedication. While early retirement isn’t for the faint of heart, it’s certainly possible if you’re committed to saving and know how to invest and grow your money over time—especially if you start early! 

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Understanding the inner workings of a Roth IRA isn’t just about crunching numbers—it’s your key to financial planning, paving the way for that cozy retirement you’ve envisioned. Knowing how Roth IRAs work empowers you to make informed decisions that align with long-term goals. 

Investors who choose Roth IRAs enjoy benefits like no required minimum distributions, no-penalty contribution withdrawals, and tax-free growth. Additionally, you can open a Roth IRA account even if you already have a 401(k), which can help you put more money toward retirement. Especially if you predict that your marginal taxes will be higher in retirement than they are right now, a Roth IRA could be a retirement savings option worth looking into.

In the upcoming sections, we’ll dive into Roth IRA mechanics, eligibility, contribution limits, withdrawal rules, and optimization strategies. Armed with this understanding, we hope you’ll leave this page feeling more confident about the next steps in your retirement journey.

In this article, we’ll cover:

• How money grows in a Roth IRA
• Who can open a Roth IRA
• Contribution limits
• Withdrawal rules and penalties
• How to get the most out of a Roth IRA

How your money grows in a Roth IRA

So how does a Roth IRA work? A Roth IRA’s purpose revolves around long-term retirement savings. You contribute after-tax funds and have the flexibility to allow your money to grow tax-free for as long as you choose. This growth emanates from two sources: 

1. The contributions you make 
2. The returns generated by investments

One of the driving forces behind the popularity of Roth IRAs is their historical average returns, which have ranged between 7% and 10%. This track record has made them an appealing investment account in addition to the tax-free growth. 

However, it’s important to remember that investments inherently carry risks due to market volatility and other variables. Past performance doesn’t ensure future results. This makes portfolio diversification vital to your retirement and investment strategy. 

Diversification is a key strategy to mitigate risk within your Roth IRA. By allocating your investments across a spectrum of assets, such as stocks, bonds, and mutual funds, you can reduce the impact of poor performance in any one area. Diversification isn’t a guarantee against losses, but it can help balance the overall risk in your investment portfolio.

Investment options

The funds you contribute to your Roth IRA can be invested in a wide variety of assets, including: 

• Stocks: Investing in shares of publicly traded companies.
• Bonds: Allocating funds into fixed-income securities issued by governments or corporations.
• Mutual funds: Pooled investments managed by professionals, offering diversification.
• Exchange-traded funds (ETFs): Similar to mutual funds but traded on stock exchanges.
• Money market funds: Investments in short-term debt securities, often considered low risk.
• Certificates of deposit (CDs): Time-bound deposits with fixed interest rates.
• Annuities: Insurance products providing regular payments, ideal for guaranteed income.
• Real Estate (with restrictions): Holding real estate properties within your Roth IRA, subject to certain limitations.

There are some types of investments that aren’t allowed, such as life insurance, collectibles, and derivative trades with unlimited risk. And while you can hold real estate in your Roth IRA, you can’t benefit directly from the property by living in it or receiving rental income.

Who can open a Roth IRA?

Anyone who has earned income, no matter their age, can contribute to a Roth IRA. However, there are income restrictions and contribution limits to consider. Regardless of your age, you must earn below a certain dollar amount annually, either as an individual or as part of a married couple, to contribute to a Roth IRA. 

The true advantage of beginning a Roth IRA journey early lies in the extended period for potential growth. Even if retirement feels distant, every year contributes to your investment’s growth potential. Starting early allows your contributions more time to compound, potentially resulting in significant financial gains over time. This extended view toward the future can make a difference in your overall retirement savings.

By grasping the flexibility and rewards of starting a Roth IRA sooner rather than later, you set yourself on a path toward maximizing the benefits of this powerful retirement investment tool.

Income limit

The IRS stipulates income limitations for contributing to a Roth IRA. As of 2023, single filers with an annual adjusted gross income (AGI) under $120,000 can contribute the full amount allowed by the IRS. Single filers earning between $138,000 and $153,000 can contribute, but the contribution limit is lower. And those earning $153,000 or more are not eligible to contribute to a Roth IRA. If you’re married and filing jointly or a qualifying widower, your combined AGI must fall below $228,000 to contribute; if your AG is over $218,000, the amount you can contribute is lower.  

Income loopholes

There is a loophole that allows high earners to get around the income limit and reap the tax benefits of a Roth IRA by making indirect contributions. This strategy, known as a “backdoor IRA,” involves making a contribution to a traditional IRA and then converting that account to a Roth IRA. The income threshold does not apply to account conversions, and you can repeat the process each year.

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Roth IRA contribution limits

Annual contribution limits apply to every Roth IRA account holder regardless of age or income. Contributions as of 2023 are limited to $6,500 per year until age 50, at which point you can start contributing up to $7,500 annually. If you earn less than the contribution limit, you can only invest up to the amount of your total taxable income for the year. And if your AGI falls into the range that reduces your contribution limit, the IRS provides a worksheet for determining your Roth IRA contribution limit based on income.

Withdrawal rules and penalties

With a Roth IRA, the IRS makes a distinction between the post-tax money you’ve contributed and the money your contributions have earned while invested in the account. You can withdraw your contributions at any time with no penalties. However, the downside of a Roth IRA is that there are strict regulations regarding when you can withdraw your earnings.  

A Roth IRA is a retirement account, and IRS regulations are designed to encourage you to keep your money invested until you reach retirement age. In most cases, withdrawing your earnings before age 59½ will incur a 10% penalty; you’ll also have to pay income tax based on your tax bracket. In addition, you must have had your Roth IRA for five years before you can withdraw earnings without penalty, regardless of your age. That said, there are some exceptions to the early-withdrawal penalties for IRAs, including purchasing your first home or paying for some education expenses.

While there are rules governing qualified distributions, you’re not actually required to withdraw funds from your Roth IRA. Unlike a traditional IRA, which mandates that you must begin taking distributions at age 72, a Roth IRA allows you to keep your money in your account indefinitely. 

What are qualified distributions?

Qualified distributions are the tax-free, penalty-free withdrawals of earnings from your Roth IRA. In practice, this generally means the withdrawals you make after you’re 59½. That said, there are a few situations in which a withdrawal is considered a qualified distribution even if it’s taken early: it qualifies for an exception, you become permanently disabled, or the distribution is made to a beneficiary or your estate after your death. 

How to get the most out of a Roth IRA

Unlocking the full potential of a Roth IRA involves strategic decision-making and a keen understanding of they work. One of the most powerful drivers of growth within a Roth IRA is compounding, a phenomenon where your contributions accrue earnings over time. Let’s explore how you can leverage this effect and optimize your Roth IRA.

The earlier you start building your retirement savings, the more time your money has to grow. Even if you can’t immediately contribute up to the annual limit, starting as early as possible gives your investments more time to compound. This compounding effect magnifies over the years, turning relatively modest contributions into substantial sums later down the road.

Here are some steps that can play a pivotal role in getting more from your Roth IRA:

• Automate contributions: Set up automatic contributions to your Roth IRA. This habit ensures consistent savings and minimizes the temptation to skip contributions.
• Rule adherence: Follow Roth IRA rules to avoid unnecessary penalties. Over-contributions and early distributions can erode the benefits of your account. Familiarize yourself with these regulations to ensure your Roth IRA remains a valuable asset.
• Maximize annual contributions: Strive to contribute the maximum allowable amount each year. As of 2023, this sum is $6,500 (or $7,500 if aged 50 or above). Regular contributions bolster the growth potential of your Roth IRA over time.
• Stay informed about contribution limits: Be aware that contribution limits can change annually based on inflation. Staying up-to-date ensures you’re taking full advantage of available allowances.

The essence of a Roth IRA lies not just in its tax benefits, but in your proactive efforts to seize its potential and secure your future.

Invest in your retirement today

A Roth IRA can be a valuable way to grow your nest egg for the future. And it doesn’t have to be your only source of retirement savings. You’re allowed to have a traditional IRA, a 401(k), and other investments in conjunction with your Roth account. 

It’s never too early to start saving for the future. With a variety of retirement accounts and investment options, Stash makes planning for the future easier, regardless of your current income level. 

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There are many types of investment accounts you can use to grow your money for retirement or other goals. One of the main reasons investors choose a Roth IRA is the potential for tax advantages later in life: if you expect to be in a higher tax bracket after you retire, you can benefit from your contributions being taxed at a lower rate when you invest now compared to the higher tax rate you expect in the future. 

In this article, we’ll cover: 

• How a Roth IRA works
• Roth IRA contributions
• Roth IRA distributions
• Investment choices in a Roth IRA
• Roth IRAs vs other retirement accounts

How do Roth IRAs work?

Investors contribute to their Roth IRA with after-tax dollars, which means they’ve already paid taxes on them. That money then grows tax-free; once you reach age 59½, qualified distributions of your contributions and earnings are tax-free. 

A Roth IRA can be opened at many banks, brokerage companies, federally insured credit unions, and savings and loan institutions. While investors can open a Roth IRA at any time, contributions for a tax year are required to take place by the investor’s tax-filing deadline, which is normally April 15 of the following year.

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Roth IRA contributions

There are several ways investors can go about getting started with a Roth IRA and a number of eligibility requirements they have to consider.

Who is eligible to open a Roth IRA?

Anyone who earns income can contribute to a Roth IRA, regardless of age. However, the IRS sets income eligibility limits for Roth IRAs. At higher income levels, investors may be able to contribute to a traditional IRA but not a Roth IRA.

If you’re a high-income investor who wouldn’t normally qualify for a Roth IRA, take a look at the backdoor Roth IRA. This loophole allows high earners to legally take advantage of Roth tax benefits.

What is the max contribution to a Roth IRA?

For 2023, investors under 50 can contribute a maximum of $6,500 to their Roth IRA, and those 50 and older can make up to $7,500 in contributions. However, that limit may be reduced based on your income and tax filing status. 

If you make over $138,000 if single or less than $218,000 if married and filing jointly, your maximum contribution limit will be lower. These income limits are updated periodically by the IRS. 

If you earn less than the contribution limit, you can only contribute up to the amount of your taxable compensation for the year. For example, earning $4,500 in 2023 means you can only contribute up to $4,500 for that year.

Notably, these investment limits apply to all IRA accounts you have combined, both Roth and traditional IRAs. For example, if you’re under 50, you could contribute $3,250 to your traditional IRA and $3,250 to your Roth IRA, for a total of $6,500 in the year.

Exceptions to Roth IRA contribution limits

There are a few special circumstances that will affect your Roth IRA contributions. 

• Employer contributions: Some small businesses and self-employed individuals can open a SEP-IRA or SIMPLE IRA. These plans allow them to contribute to their employees’ retirement; keep in mind that there are generally limits on employer contributions. If your employer contributes to one of these accounts for you, that doesn’t count toward the maximum contribution you can make to any personal IRA accounts you have. For instance, you can contribute $6,500 to your Roth IRA if you’re under 50, even if your employer contributes money to your SEP-IRA. 
• Spousal IRA contributions: Generally, taxable compensation is required in order to contribute to a Roth IRA. However, if you’re married and file your taxes jointly, a spouse who doesn’t earn any income can open a spousal IRA, and the working spouse can contribute to that account up to the annual limit. That’s in addition to the annual limit for their own Roth IRA. There are, however, some restrictions on spousal IRA contributions. 
• Reduced contribution limits: For a full breakdown of how much you can contribute at different income levels and filing statuses, check out the IRS table on reduced contribution limits for Roth IRAs. 

How to contribute to a Roth IRA 

• Regular contributions: Regular contributions must be made in cash and can’t include things like property, securities, rental income, or interest income. Generally, you can only contribute earned income such as salary, wages, commissions, and bonuses. If you’re self-employed, your earned income is your net earnings from your business minus deductions to other retirement plans and taxes. 
• Transfers: A transfer, also called a direct transfer or a trustee-to-trustee transfer, means one Roth IRA custodian sends money directly to another Roth IRA custodian, and the money does not pass through an individual’s hands. With a direct transfer, no taxes are withheld.
• Rollover contributions: Investors who have a Roth 401k, in which they’ve already paid taxes on their contributions, are able to roll that money into a Roth IRA. Rollover contributions do not count towards their yearly contribution limit. This IRS rollover chart explains what types of accounts can be rolled over and the relevant restrictions. 

Roth IRA distributions

A Roth IRA is a retirement account and, like all retirement accounts, comes with rules and penalties around how and when you can withdraw your investments.

When can you withdraw from a Roth IRA?

There are two types of penalty-free distributions, or withdrawals, from your Roth IRA. 

• Initial investment: The money you put into your Roth IRA is relatively liquid. You can withdraw up to the sum you put into the account without paying taxes or penalties. Your contributions are not considered taxable income because you already paid taxes on that money before putting it in the account.
• Qualified distributions: A qualified distribution is a withdrawal that takes place at least five years after you started making contributions and is taken when you are either at least 59½ years old, you are disabled as defined by the IRS, or the a distribution is to a beneficiary of your estate following your death. 

The five-year rule

The Roth IRA five-year rule says that you cannot withdraw earnings tax-free until it’s been at least five years since you first contributed to a Roth IRA account. This five-year waiting period applies even to those aged, 59 ½ and older, who would otherwise get qualified distributions. 

Early distribution penalties

People investing for retirement lose out on the tax advantages of a Roth IRA if they take out their money early. If you withdraw earnings that don’t meet the rules for a qualified distribution, you’ll have to pay income tax on that money, plus a 10% penalty tax. There are a few exceptions, such as money withdrawn for a first-time home purchase and qualified educational expenses. You can find details on all the exceptions to the early distribution penalty at the IRS website.  

Investment choices in a Roth IRA

Roth and traditional IRAs are both relatively straightforward accounts once you’ve met their requirements and understand their limitations. You can choose the investments in your Roth IRA yourself or use robo-advisor to put your money to work in several different kinds of investments. 

Investments you can make in your Roth IRA include:

• Individual stocks
• Individual bonds
• Exchange-traded funds (ETFs)
• Index funds
• Mutual funds

Keep in mind that Roth IRA accounts are investment vehicles, not investments in and of themselves. You can make money with a Roth IRA by investing your contributions in securities. That means you must put your contributions into an investment once you’ve opened your account, or your money won’t be doing any work for you. When you open a Roth IRA, be sure you understand how the financial institution handles your contributions when you make them to ensure your money is being invested, not just sitting around as cash.  

Pros and cons of a Roth IRA 

Roth IRAs can be a powerful vehicle in your retirement investing strategy, but they also come with a number of drawbacks investors should consider. 

Benefits of a Roth IRA

• Tax-free growth: Investors enjoy tax-free growth on their investments. As long as you withdraw your earnings after you’re 59½ and have met the five-year rule, you don’t pay any tax on your earnings.
• Tax-free distributions: Investors don’t have to pay taxes on their withdrawals because they paid their taxes up front, possibly when they were in a lower tax bracket. 
• Can withdraw contributions before retirement: The money you contribute to the account is liquid, which means you can withdraw your contributions anytime without any penalties should you need that money. 
• Flexible timing: While investors have an annual contribution limit, they can contribute up to that limit anytime during that tax year. So you could contribute a little bit from each paycheck throughout the year so that you’re adding money to your retirement account on an ongoing basis. 
• No distribution minimums: Upon retirement, investors don’t have required distributions, so they can theoretically hold money in their account as long as they want. This is a major difference between Roth IRAs and traditional IRAs; some investors opt for a Roth IRA because they want to keep their money invested for as long as possible or pass their IRA down to their heirs after death.

Drawbacks of a Roth IRA

• No tax-deductible contributions: Unlike with a traditional IRA, you cannot deduct your contributions from your taxable income because you’ve already paid taxes before depositing your money into a Roth IRA. 
• Income limit: If you earn more than the income limits, the amount of money you can contribute will be reduced. Some people earn too much to contribute to a Roth IRA directly and must use a backdoor Roth IRA or traditional IRA instead.
• Withdrawal taxes and penalties: Any withdrawals that aren’t qualified distributions are subject to taxes and penalties, barring certain narrow exceptions. These penalties may outweigh any tax advantages you gain with a Roth IRA.  
• Low maximum contribution: The maximum contributions you can make to a Roth IRA are relatively low. Many investors will likely need other retirement vehicles in order to save enough for retirement.
• No employer matching: Unlike a 401(k) or other employer-sponsored retirement account, a Roth IRA does not provide opportunities for employer contributions. 

Roth IRA vs. traditional IRA vs. 401(k)

A Roth IRA, traditional IRA, and 401(k)s are all types of retirement accounts. Each account has different rules, limitations, and benefits that investors can take advantage of, and many people will hold all of these account types. 

Remember, investors are allowed to have all these investment vehicles at the same time. Many people invest in a 401(k) up to the amount their employer matches in order to take make full use of that benefit, then “max out” their contributions to a Roth IRA or traditional IRA. By diversifying where you make your retirement investments, you can take advantage of the different benefits offered by the different account types. 

Is investing in a Roth IRA right for you? 

Once you understand what a Roth IRA is and what it can do for you, you may want to jump right in. But it’s important to take a look at this tax-advantaged retirement account from the perspective of your whole portfolio.

A Roth IRA can make a lot of sense at certain points in your life, but whether or not it’s right for you comes down to how much money you’re making now and how much you expect to make when you stop working. Young investors who expect to make more money in the future could benefit from front-loading their tax burden; you can pay taxes on your money now while you’re in a lower tax bracket, then let it grow tax-free in a Roth IRA. 

Other investors may benefit more from a traditional IRA or 401(k) because those contributions are tax-deductible, which could lower your tax burden for the years in which you contribute.

Which tax-advantaged retirement account, or combination of accounts, is right for you will depend on your unique situation and plans for the future. In any case, it’s never too early to start saving for retirement. The sooner you start, the more wealth you can accumulate for your golden years.  

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The IRS limits how much you can contribute to your Individual Retirement Account (IRA) each year. In general, investors under the age of 50 may contribute up to $6,500 to a Roth IRA or traditional IRA during the 2023 tax year. Investors 50 and older can make an annual catch-up contribution of $1,000, making their yearly contribution limit $7,500. 

However, unlike traditional IRAs, the Roth IRA is subject to an annual income limit and other factors that may impact the amount you can contribute or your ability to contribute at all. Knowing your contribution limit is important, as you can incur penalties if you contribute more to your Roth IRA than is allowed based on your income and filing status. Currently, the IRS charges a 6% excise tax for every year a contribution that exceeds the limit stays in your account.

Factors that affect your contribution limit

Things like age, annual income, and tax filing status affect IRA contribution limits. Roth IRAs are subject to more potential limitations on contributions than traditional IRAs.

• Age: Anyone with taxable earned income is eligible to contribute to a traditional or Roth IRA, regardless of age. Investors under the age of 50 may contribute up to the annual limit, and investors over 50 may put in an additional $1,000 catch-up contribution each year.
• Modified adjusted gross income: If you have a Roth IRA, your modified adjusted gross income (MAGI) affects your contribution limit. Your MAGI is your total gross earned income minus some specific deductions. For single tax filers in 2023, if your MAGI is less than $138,000 and you meet certain IRS filing status requirements, you can contribute up to the annual limit to your Roth IRA. Higher or lower MAGIs, in conjunction with tax filing status, may reduce or zero out the amount you’re allowed to contribute. If you have a traditional IRA, your MAGI does not affect your contribution limit.
• Filing status: Your tax filing status is also a factor in your contribution limit for a Roth IRA, but not a traditional IRA. If you are single or married and filing jointly and within the MAGI limits, you may contribute up to the annual limit for your Roth IRA. Some other filing statuses may reduce or zero out the amount you’re allowed to contribute, depending on your MAGI.
  Contributions to other IRAs: While you can have both a traditional IRA and a Roth IRA simultaneously, the contribution limits apply to your combined IRA contributions. For example, if you are eligible to contribute $6,500 for 2023, that’s the total amount you can contribute to all your IRAs combined; you cannot contribute $6,500 to a traditional IRA and another $6,500 to a Roth IRA. 

Calculating your modified adjusted gross income

Calculating your MAGI may seem a little complicated, so here’s a quick rundown. First, you should calculate your annual adjusted gross income (AGI), which encompasses all your earned income for the year, including wages, tips, royalties, alimony, retirement income, business income, interest, capital gains, and dividends, minus certain tax-deductible expenses. 

Once you’ve calculated all of your earnings for the year, you will subtract applicable business expenses, retirement plan contributions, student loan interest payments, educator expenses, HSA contributions, and other allowed deductions. This is your AGI. 

To calculate your MAGI, start with your AGI, then add back the deductions specific to your situation outlined by the IRS. The IRS provides a handy worksheet for calculating your MAGI, and you’ll just need info from your tax documents to fill it out.

Roth IRA contribution limits by filing status

The IRS adjusted traditional IRA contribution limits for 2023, increasing the annual limit to $6,500 for investors under 50 and $7,500 for investors 50 and older. However, contribution limits vary according to tax filing status and MAGI.

Single, head of household

You can choose single filing status if you’re not legally married. And, If you meet certain conditions, you may also choose to file your taxes as head of household. To claim head of household status, you must be legally single or living apart from your spouse for the last six months of the year, pay more than half of household expenses, and have either a qualified dependent living with you for at least half the year or a parent for whom you pay more than half their living expenses.

Single or head of household filers with a MAGI of less than $138,000 may contribute up to the yearly limit for a Roth IRA. Those who earn more than $138,000 but less than $153,000 may contribute a reduced amount, and those earning more than $153,000 are not eligible to contribute to a Roth IRA. These limits also apply to those filing as a qualifying widow(er).

Married and filing jointly

Filing jointly means that you and the person to whom you are legally married file a single tax return that includes all income and deductions for both people. If your joint MAGI is less than $218,000, each spouse may contribute up to the limit to Roth IRAs. Your contribution limit will be reduced if your joint MAGI falls between $218,000 and $228,000. Neither of you will be eligible to contribute if your joint MAGI exceeds $228,000 annually. 

Married and filing separately

If you’re married filing separately, you and your spouse each file your own tax return. This requires separating your income and deductions. In this case, your contribution limit will be reduced, and you won’t be able to contribute at all if your MAGI is over $10,000.

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Traditional IRA deduction limits by filing status

Contribution limits for traditional IRAs in 2023 are the same as those for Roth IRAs: $6,500 if you’re under 50 and $7,500 if you’re 50 or older. However, your MAGI and tax filing status don’t come into play when determining your contribution limit for a traditional IRA.

Deduction limits are a bit more complicated. Unlike with a Roth IRA, you can usually deduct some or all of your traditional IRA contributions from your taxable income for the year. If neither you nor your spouse have an employer-sponsored retirement plan, like a 401(k), you can take a full deduction up to your contribution limit. If you do have an employer-sponsored plan, however, the IRS imposes some limitations based on your MAGI and tax filing status. The tables below reflect traditional IRA deduction limits for 2023 if you or your spouse has a 401(k) or other employer-sponsored retirement plan.

Single, head of household

Single or head of household filers with a MAGI of $73,000 or less may take the full deduction, but those who earn $83,000 or more are not eligible. 

Married and filing jointly

If your combined MAGI is $116,000 or less, you may take the full deduction up to the amount of your contribution limit. Couples with a MAGI higher than $136,000 are not eligible for a deduction.

Married and filing separately

If you and your spouse are married and filing separate tax returns, your deduction limit will be reduced. Filers with a MAGI of less than $10,000 are eligible for a partial deduction, while those earning $10,000 or more are not eligible.

It’s never too early to think about retirement

Whether you choose a Roth IRA, a traditional IRA, or another type of retirement savings account, it’s never too early to start investing. The longer your money is invested, the more time it has to grow. Factors like inflation and penalties for early withdrawal may affect your retirement account balances over the years, so it’s wise to research all your options.

You don’t have to choose just one way to save for retirement, either. Remember that you can have more than one IRA, as well as an employer-sponsored retirement plan like a 401(k), all at the same time. In fact, many people choose to contribute to both a 401(k) and an IRA in order to put away more money than IRA contribution limits allow.

Stash can help you prepare for retirement your way with both Roth and traditional IRA investment options. Start planning for your financial future today.

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With many types of retirement accounts available, choosing the right one for your financial future can be overwhelming. Roth IRAs and 401(k)s are two popular options; both provide tax advantages and can help you grow your investments over the long term. 

In this article, we’ll cover:

• Roth IRAs and their features
• 401(k)s and their features
• Roth IRA vs. 401(k)
• Factors for choosing between a Roth IRA and a 401(k)

What is a Roth IRA?

A Roth Individual Retirement Account (IRA) is a tax-advantaged retirement account in which contributions are made with after-tax income; you put money into the account after you have paid income tax on it. Roth IRAs are subject to income eligibility rules and contribution limits set by the IRS, which are similar to those for traditional IRAs and may change from year to year. The key benefit of a Roth IRA is that qualified withdrawals in retirement are tax-free, for both the contributions you make and the money you earn on those contributions while they are invested in the account.

Eligibility requirements

To contribute to a Roth IRA, you have to meet certain requirements when it comes to your earned income and Modified Adjusted Gross Income (MAGI). To qualify, you must earn income, such as wages, salaries, or self-employment income, and your MAGI must fall within specific limits, which depend on your tax filing status. If your income exceeds the upper limit for your filing status, you may be unable to contribute, or limited to a lower amount.

Contribution limits and deadlines

For the 2023 tax year, total contributions for Roth IRA accounts are capped at $6,500, and you must make contributions by April 15, 2024. If you’re 50 or older, you can make an additional catch-up contribution of $1,000, bringing your total contributions to $7,500.

This limit differs depending on your income and tax filing status. For instance, Roth IRA contribution limits are lower for single filers making more than $138,000 and people who are married, filing jointly who make over $218,000. And if your income is lower than the contribution limit, you cannot contribute more than your MAGI for the year. 

Tax implications

Tax advantages are a primary appeal of a Roth IRA, and it’s important to understand how they work to ensure you benefit from them. 

• Contributions: Contributions are made to a Roth IRA with after-tax income. Because you have already paid taxes on this money before depositing it into the account, you can withdraw it at any time with no penalties, and you will owe no taxes. 
• Earnings: Money generated by the investments in your Roth IRA is tax-exempt as long as you follow the withdrawal rules.
• Withdrawals: Withdrawals of your earnings are tax-free once you reach the age of 59½, as long as the account is at least five years old.

If you withdraw your earnings before you’re 59½, you’ll have to pay income tax on the money, plus an additional 10% early-distribution tax. There are a few exceptions to the early-distribution tax, like withdrawing money for education expenses or buying your first home. But even in these cases, you’ll owe income tax on earnings if you withdraw them early.

Investment options and flexibility

With a Roth IRA, you can invest in a wide range of assets. In addition to the typical options like stocks, bonds, mutual funds, index funds, and exchange-traded funds (ETFs), a self-directed Roth IRA allows you to expand your investment into assets like real estate, private equity, precious metals, and more. With more flexibility and control over your choice of assets, you can diversify and potentially capitalize on different investment strategies. 

Advantages and benefits

A Roth IRA offers several advantages that can enhance your retirement strategy. This type of account offers more flexibility in managing your investments and provides a level of accessibility to your funds in case of emergency financial needs.

• Tax-free withdrawals in retirement: Qualified withdrawals after the age of 59½ from a Roth IRA are tax-free, including both contributions and investment earnings. That means you pay no tax at all on your earnings if you follow the withdrawal rules.
• No required minimum distributions (RMDs): Unlike traditional IRAs, Roth IRAs do not have required minimum distributions, or mandatory withdrawals, during the account holder’s lifetime. That allows you to keep your money growing in the account for as long as you like, and even pass it on to your heirs.
• Penalty-free withdrawal of contributions: Roth IRA accounts allow you to withdraw your contributions at any time without incurring penalties or paying additional taxes. Note that this applies only to the after-tax money you have directly contributed, not to earnings on your investments.

Disadvantages and limitations

Before you open a Roth IRA for your retirement plan, it’s important to acknowledge its potential disadvantages, specifically when it comes to your tax bracket and filing method. Depending on your income, marital status, and how you choose to file your taxes, you may be ineligible or your maximum contributions may be limited.

• Income limitations on eligibility: In 2023, individuals making $153,000 or more per year cannot contribute, and those making more than $138,000 per year are subject to a lower contribution limit. Married couples filing jointly and making more than $218,000 per year are ineligible, and those making between $218,000 and $228,000  are also limited to a lower contribution amount.
• Contributions are not tax-deductible: Unlike 401(k)s and traditional IRAs, contributions to a Roth IRA are made with after-tax income, so you cannot deduct them from your taxable income for the year.

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What is a 401(k)?

A 401(k) is a retirement saving plan offered by employers in which you can put a portion of your pre-tax income into an investment account. Because you’re contributing money before it’s taxed, putting funds into a 401(k) reduces your taxable income, which may reduce the amount you pay in taxes during the years you contribute. Your employer might also match a portion of your contributions, adding money to your 401(k) account on your behalf. And you can roll the account over if you change jobs.

Eligibility requirements

To contribute to a 401(k), individuals must meet certain eligibility requirements set by their employers. These requirements may include factors such as being at least 21 years old, completing a specified period of service with the company, or being classified as a full-time employee. Employers have the discretion to set additional eligibility criteria for their 401(k) plans, so it’s important to consult the plan’s documentation or your HR department to understand your specific requirements.

Contribution limits and deadlines

The annual cap on 401(k) contributions is significantly higher than the limit for Roth IRA accounts. For 2023, the contribution limit for 401(k) plans is $22,500. Additionally, employees over the age of 50 can contribute another $7,500 as part of a catch-up contribution. Unlike Roth IRAs, which have a 2023 tax year deadline of April 15, 2024, all contributions to a 401(k) must be made by December 31, 2023. 

Tax implications

The tax advantages differ between a Roth IRA vs. a 401(k), with the primary distinction being when taxes are assessed and how taxes are applied to contributions and earnings.

1. Contributions: Contributions to a 401(k) are made with pre-tax income, meaning they are deducted from your paycheck before taxes are applied. 
2. Earnings: Contributions and any investment earnings in a 401(k) are taxed when withdrawn in retirement.
3. Withdrawals: Withdrawals from a traditional 401(k) are subject to ordinary income tax rates at the time of withdrawal.

Investment options and flexibility

The investment options within a 401(k) are typically limited to a selection of funds chosen by the employer or plan administrator. These funds often include a range of mutual funds, such as stock funds, bond funds, and target-date funds. However, compared to other retirement plan options like IRAs, 401(k) accounts generally have fewer investment choices.

Advantages and benefits

Investing in a 401(k) offers several advantages, including the ability to contribute more through matching contributions from your employer, higher limits to your contributions, and the potential to lower your annual taxable income. 

• Employer matching contributions: Many employers offer a matching contribution to employees’ 401(k) accounts as a benefit of employment. This matching contribution can significantly boost your retirement savings over time.
• Higher contribution limits: Compared to IRAs, 401(k) plans allow for higher annual contribution limits, allowing you to put away more toward retirement.
• Pre-tax contributions reduce taxable income: Contributions to a traditional 401(k) are made with pre-tax income, reducing your taxable income for the year. Additionally, both contributions and investment earnings grow tax-deferred until withdrawal in retirement.

Disadvantages and limitations

Investing in a 401(k) account also comes with certain potential challenges. Consider the following factors:

• Limited investment options: Compared to Roth IRAs, 401(k) plans typically offer a limited menu of investment choices, which are often pre-selected by your employer. This leaves you with less control and flexibility when it comes to how you invest your money. 

• Required minimum distributions starting at age 72: Once you reach age 72, you’re generally required to start taking minimum distributions, or mandatory withdrawals, from your 401(k) account. These are subject to taxes at the rate of the time of withdrawal which may impact your cash flow in retirement.

Roth IRA vs. 401(k): how do they compare?

Both Roth IRAs and 401(k)s offer valuable tax advantages and opportunities for achieving your financial goals over the long term, but they have distinct features that can significantly impact the money you’re able to save for retirement. While a Roth IRA allows for tax-free withdrawals in retirement and greater control over investment choices, a 401(k) offers the potential for employer-matching contributions and higher contribution limits. 

Factors to consider when choosing between a Roth IRA and 401(k)

When weighing a Roth IRA vs. a 401(k) for your retirement planning, take into account all aspects of your financial picture, including your earnings, tax bracket, and short- and long-term goals. 

• Current and projected income: Contributions to a 401(k) are made before taxes, which can lower your current tax burden. And if you expect to be in a lower tax bracket after you retire, it may benefit you to pay taxes on your contributions at that time. By deferring tax payments, you can potentially enjoy tax benefits while saving for retirement.
• Tax bracket and expected future tax rates: If you expect to be in a higher tax bracket at age 59½  than you are now, a Roth IRA allows you to pay income tax on your contributions at your current rate, then enjoy tax-free withdrawals later.

• Employer contributions and matching: If your employer offers a matching contribution, taking full advantage of this benefit can help you put away even more money for retirement. That money is part of your total compensation package, but you only get it if you contribute to your 401(k).
• Investment options and preferences: A Roth IRA typically offers a broader range of investment choices compared to the limited options offered with a 401(k). If you prefer more control over your investment strategy, a Roth IRA may interest you.
• Long-term retirement goals and financial plans: Consider the role your account will play in your overall financial plan. Evaluate factors such as your desired lifestyle in retirement, your liquidity needs, and other sources of income. If you hope to retire early, for instance, you may appreciate the ability to withdraw your contributions from a Roth IRA without penalty. 
• Risk tolerance and investment strategy: A Roth IRA offers more control over investment choices, allowing you to tailor your portfolio to your risk tolerance and investment preferences. A 401(k) may have limited investment options, but it can still be suitable if the available choices align with your investment strategy.

Roth IRA vs. 401(k): which is right for you? 

Both Roth IRAs and 401(k)s feature unique benefits, limitations, tax advantages, and investment options to evaluate as you choose the right retirement plan for you. And it’s simple to open either type of account and start making contributions.

And you don’t have to decide between a Roth IRA vs. 401(k); you’re allowed to have both types of accounts. If you’re already contributing to your employer’s 401(k), opening a Roth IRA can be an opportunity to save more for retirement. Depending on your overall financial goals, you may even wish to explore more types of investment accounts for building long-term wealth.

Whichever path you choose, the earlier you start saving for retirement, the more time your investment will have to grow. 

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Roth IRA and 401K FAQ

Can you invest in both a 401(k) and a Roth IRA?

You can have both. Even if your employer offers a 401(k), you can open a Roth IRA and contribute up to the maximum allowed for each account. If saving for retirement is a high priority for you, this can be a good way to maximize the amount you can invest.

If your employer offers matching contributions, you may want to contribute enough to get the full match, and then invest in a Roth IRA. If you’re able to fully fund the Roth IRA, you can put any additional deposits into the 401(k), up to the annual limit.

When should you not invest in a Roth IRA?

With any tax-advantaged retirement account, you’re trading tax benefits for keeping money in the account until retirement. So if you expect to need your money before you reach retirement age, a Roth IRA may not be the right choice for you. Also, if you expect to be in a lower tax bracket when you retire than you are now, you might save money by paying taxes when you withdraw money, rather than when you contribute it. Finally, if reducing your tax burden now by investing pre-tax dollars is important, a Roth IRA won’t give you that advantage.

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Are you one of the 36.8 million people contributing to a traditional IRA but making $150,000 or more? Did you know that high-income individuals can open a Roth IRA to save on taxes, even though the IRS technically doesn’t permit it?

It’s true. The IRS sets this rule to create a level playing field amongst lower-paid investors, but there’s a catch—you still can with a backdoor Roth IRA. Backdoor Roth IRAs are a loophole around Roth income limits.

And if you’re laughing to yourself, thinking that this strategy doesn’t apply to you, you never know what—or how many dollar signs—the future holds. If new career opportunities open up for you, you may find yourself in a higher salary bracket and unable to open a Roth IRA the typical way.

Follow along to discover the ins and outs of backdoor Roth IRAs, including how to start one and adhere to tax implications.

What is a backdoor Roth IRA?

Best for: single investors with an adjusted gross income (AGI) of over $153,000 and joint filers earning $228,000 or more

The backdoor Roth IRA is an investing strategy, not a true IRA type. In the grand scheme, a backdoor Roth IRA works the same as a regular Roth IRA but is funded differently and subject to a few tax particularities.

Anyone can open a traditional IRA—there are no income limits—yet high earners can’t open a Roth IRA without using a backdoor strategy. Reminder: the key distinction between Roth and traditional IRAs is taxes. Pre-tax dollars fund traditional IRAs, whereas Roth IRA contributions are after-tax.

The backdoor Roth strategy lets investors convert traditional IRA funds into Roth IRA investments and reap the tax benefits—tiptoeing around Roth income limits legally. As of 2023, the IRS does not crack down on this strategy.

Who qualifies as a high earner? In 2023, the IRS income requirements for Roth IRAs are:

• $153,000 for single or head of household filers and those married filing separately (and not living together)
• $228,000 for joint filers and qualifying widow(er)

Married individuals filing separately who earn $10,000 or less (and living with one another) also do not qualify for Roth IRAs. However, those in this income bracket should prioritize other financial goals, like increasing their incomes and building savings, before considering a backdoor IRA.

How to set up a backdoor Roth IRA

Backdoor Roth IRAs may seem intimidating, but they aren’t overly complicated to set up. Here’s a simple three-step guide to help you set up your backdoor Roth IRA.

1. Contribute to a traditional IRA

The first and simplest step of the backdoor Roth strategy is to open a traditional IRA. You can skip this step if you already have a traditional IRA. Some employer 401(k) plans may allow rolling funds into a Roth IRA. However, individual traditional IRAs typically fund backdoor Roth IRAs.

When opening a traditional IRA, pick a company you trust. You can either work with a brokerage or robo-advisor—both have advantages and disadvantages. However, if your sole strategy is to transfer to a backdoor Roth IRA, you may want to opt for assistance with a broker.

After you open the account, you can begin to contribute pre-tax dollars. You can contribute throughout the year or max out your contributions right away to begin the transfer process. Maxing out your contributions isn’t necessary, but it’s wise if you can afford it.

2. Turn your traditional IRA into a Roth IRA

Converting your traditional IRA into a Roth IRA should be simple. The first part of this step is to open a Roth IRA if you haven’t already. From there, each brokerage handles the transfer process differently—it could be the click of a button, or you may need to complete paperwork. Consult your broker to make sure.

Transfers are possible in one of three ways:

• Rollover: If you withdraw from a traditional IRA, you must transfer it to a Roth IRA within 60 days.
• Same trustee transfer: You plan to use the same financial institution to operate your Roth IRA that maintained your traditional IRA.
• Trustee-to-trustee: The financial institution holding your conventional IRA transfers a predetermined percentage of your assets to the new broker or bank maintaining your Roth IRA.

Keep in mind how much you want to transfer into the Roth IRA. You can roll over as much or as little as you’d like, though the more you convert, the higher your taxes will be.

Investor tip: Wait a few months after contributing to your traditional IRA before converting it to a Roth IRA. If you max out your traditional IRA and instantly convert it to a Roth, the IRS may see this as a single transaction and penalize you.

3. Pay taxes with the pro rata rule

Backdoor Roth IRAs aren’t a strategy for skirting taxes. Roth contributions are always after-tax, even with a backdoor approach.

The downside here is you can be taxed on your entire Roth contribution amount—including contributions and earnings from your traditional IRA. Backdoor Roth IRAs are subject to the IRS pro rata rule, which determines how pre-tax assets will be taxed upon transferring to an after-tax account like a Roth IRA.

The pro rata rule states backdoor Roth IRAs are taxed proportionately between pre- and after-tax contributions. It takes the percentage of your aggregated IRA balances and configures the percentage that still has yet to be taxed.

For example, imagine that you have $43,500 in a traditional IRA. Say you contributed the annual max of $6,500 to a new traditional IRA and then rolled that contribution only into a backdoor Roth IRA. To the IRS, you have $50,000 in traditional IRAs, but only 13% of your IRA total is after-tax dollars (from that last contribution). This means only $845 is tax-free (13% of $6,500), so you owe taxes on the remaining $5,655.

During tax season, you’re responsible for completing the backdoor Roth IRA tax form, the standard 8606 Form, to claim your nondeductible IRA contributions.

Additionally, if you benefited from a tax break from your traditional IRA contributions beforehand, you’ll be expected to repay those deductions. These tax stipulations may increase your taxes in the short term, but withdrawals are tax-free, so you will likely benefit in the long run.

Disclosure: This should not be construed as tax advice. Please consult a tax professional for additional questions.

Roth IRA: Withdrawals of the money (Contributions) you put in are penalty and tax free. Prior to age 59½, withdrawals of interest and earnings are subject to income tax and a 10% penalty. All earnings are tax free at age 59½ or older, assuming your first contribution was more than 5 years prior. Income Eligibility applies.

When shouldn’t you open a backdoor IRA

Backdoor Roth IRAs aren’t for everyone. This strategy can lead to unexpected costs or may not benefit you as you envision.

Here are a few examples of when it makes sense not to open a backdoor Roth IRA.

• If you’re allowed to contribute to a Roth IRA—there’s no reason to make investing harder than it should be
• If you have short-term financial goals, like paying off personal loans
• If you might need your savings within the next five years
• If you’re older than 60 and your backdoor Roth IRA could negatively impact your Social Security and Medicare benefits
• If your tax rate might be lower in retirement

FAQ

Not sure if a backdoor Roth IRA is right for you? Let us answer all of your remaining questions.

Are backdoor Roth IRAs still allowed in 2023?

Yes, backdoor Roth IRAs are legal in 2023, but that might not always be true. Since 2010, the IRS has allowed the backdoor Roth IRAs loophole. However, this could change in the future if the IRS changes violation determinations—and previous administrations have considered it.

Do you pay taxes on backdoor Roth IRAs?

Yes, you must pay taxes on a backdoor IRA. Traditional IRA contributions are tax-free. However, when you transfer your funds into a Roth IRA, those assets are viewed as contributions, so the entire amount is taxed—principal, earnings, and interest. However, you will not pay taxes again when you withdraw.

What is a mega backdoor Roth IRA?

A mega backdoor Roth IRA is a specific type of backdoor Roth strategy where maxed-out 401(k) employer plans fund the account.

Traditional 401(k) plans have a $20,500 annual contribution limit. However, some employers offer after-tax 401(k)s, which allow an additional $43,500 in annual contributions (totaling $66,000, including employer matching). Rolling both maxed-out plans into a Roth IRA is considered a mega backdoor Roth IRA.

Mega backdoor Roth IRAs can be tricky, even for the experienced investor. Consider turning to a tax professional to convert funds to a mega backdoor Roth.

Who qualifies for a backdoor Roth IRA?

Anyone eligible to contribute to a traditional IRA also qualifies for a backdoor Roth IRA. However, many people eligible for a traditional IRA also qualify for a Roth IRA, meaning the backdoor IRA strategy isn’t necessary.

Backdoor Roth IRA rollovers make the most sense for individuals earning more than the IRS’s income requirements. If your income is less than the IRS’s requirements, you can contribute directly to a Roth IRA and do not need the backdoor option (some may only qualify for a reduced contribution limit).

Are backdoor IRAs worth it?

Yes, a backdoor Roth IRA may be worth it if you’re not eligible, based on income limits, to contribute directly to a Roth IRA. While your assets can grow exponentially in a traditional IRA, you could save thousands in taxes by converting to a backdoor Roth.

Backdoor Roths aren’t as complicated as they sound. Tax season can make backdoor Roths a little tricky, but they’re still manageable as long as you fully understand how they work.

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The post How to Set Up a Backdoor Roth IRA: A Step-by-Step Guide appeared first on Stash Learn.