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What if you could save for retirement, earn compound interest and get a huge tax break all at the same time?

With a Roth IRA, you can.

It’s surprising, then, that more Americans aren’t taking advantage. Close to 40% have less than $10,000 socked away for retirement, and more than a fifth have less than $5,000, according to a study from Northwestern Mutual.

Nearly half haven’t even started planning for their golden years.

At any age, opening a Roth IRA makes great financial sense.

How a Roth IRA works

Roth IRAs are investment accounts designed to pay off big in retirement. The "IRA" part stands for "individual retirement account" or "individual retirement arrangement."

Unlike other retirement savings plans, Roth accounts are funded with money that's taxed upfront. That means any withdrawals you make against your contributed amounts now or in retirement are tax-free.

You can face taxes and penalties if you withdraw your earnings too soon, and the accounts have certain rules and limitations. But in general, Roth IRAs are popular for their advantages and flexibility.

Contributions go toward investments of your choice, such as stocks, bonds, ETFs or mutual funds. Stocks and bonds typically have the highest returns.

How a Roth IRA grows your money

Even if you’re not able to contribute during a few lean years, your money in a Roth IRA will continue to grow through the wonder of compound interest. Simply put, your investments earn returns — and so do the earnings themselves.

Here’s an example of the beauty of compounding on a Roth IRA:

A bright 20-year-old saves $5,000 a year in a Roth IRA for 10 years. She never makes another contribution.

Earning, say, 8% returns, she would still wind up with more than $180,000 at age 65. Being a sharp cookie, she probably has much more than that, because she continued saving and investing in other ways.

Roth IRA accounts just keep on growing, and the withdrawals can be totally tax-free — provided she doesn't take the money out too early.

The benefits of a Roth IRA

The biggest benefit is the tax incentive, especially for younger people who open Roth IRAs while they’re still in the lowest tax bracket.

Presumably, their income will increase as they grow older, meaning their contributions will then be taxed at higher rates.

Here are some additional advantages:

  • You can open a Roth IRA at any age, and there are no limits on how long you can contribute.

  • Unlike a traditional IRA, a Roth doesn’t have mandatory withdrawals. You can leave the money untouched for as long as you like.

    For instance, well-to-do older taxpayers who don’t need the money can let their Roth IRAs sit and continue to grow. If the assets are correctly passed down to heirs, the heirs won’t owe taxes on them.

  • You can withdraw from the amount you contributed at any time and for any reason without penalty. The rules for withdrawing from investment earnings are outlined further down.

Roth IRA limits

These are wonderful accounts, but you have to play by the Roth IRA rules. Also, make sure to base your moves on current information. Roth IRA contribution limits and income limits are sometimes adjusted.

The 2019 Roth contribution limits according to filing status and adjusted gross income are as follows:

Married filing jointly or qualifying widow or widower:

If you earn less than $193,000, the maximum annual contribution is $6,000, or $7,000 if you’re at least 50. If you earn between $193,000 and $202,999, the contribution is reduced. You're not eligible for a Roth IRA if you earn $203,000 or more.

Single, head of household or married filing separately (if you didn’t live with your spouse during the year):

If you earn less than $122,000, the maximum contribution is $6,000, or $7,000 if you’re at least 50. If you earn between $122,000 and $136,999, the contribution is reduced. You're not eligible for a Roth IRA if you earn $137,000 or more.

Married filing separately (if you lived with your spouse at any time during the year):

If you earn less than $10,000, the contribution is reduced. You're not eligible for a Roth IRA if you earn $10,000 or more.

A Roth IRA vs. a traditional IRA

There are both similarities and differences between the two primary types of IRAs. Here’s how they compare:

Roth IRA vs. Traditional IRA
Roth IRA Traditional IRA
Age requirements Can contribute at any age. Can contribute until you're 70½.
Income requirements Your income affects the amount you can contribute. There are no income limits.
Tax incentives Growth and qualified withdrawals are tax-free. Contributions are tax-deductible, and growth is tax-deferred.
Withdrawal taxes Earnings are tax-free if withdrawn at age 59½ or later. And, the account must be at least 5 years old. Both contributions and earnings are taxed when they’re withdrawn.
Early withdrawal penalties Earnings are subject to a 10% penalty if withdrawn before age 59½. All withdrawals are subject to a 10% penalty before age 59½.
Required minimum distributions (RMDs) These mandatory withdrawals are required only after the passing of the account owner. RMDs must be taken starting in the year you turn 70½.

As you can see, one size doesn’t fit all. Your banker or financial adviser can recommend the best account for your circumstances.

A Roth IRA vs. a 401(k)

A 401(k) is an employer-sponsored savings plan. Employees contribute a portion of every paycheck before taxes are deducted. With any luck, the boss offers a match.

Investment choices depend on the 401(k) plan provider, but they can be somewhat limited. Withdrawals — including investment gains — are subject to income taxes, and there's a 10% penalty for withdrawals made before age 59½.

Here's how Roth IRAs are different from 401(k)s:

  • Employers are not involved in Roth IRAs, which are set up directly between individuals and financial entities.
  • Roth IRAs typically have more investment choices.
  • They're funded with money that’s already been taxed. Contributions are never taxed again, and investment gains are taxed only when they're withdrawn too early.

It never hurts to have both a 401(k) and a Roth IRA, if possible.

How to open a Roth IRA

Most banks and brokerages — both traditional and online — handle Roth IRAs. You can even open a Roth IRA through an automated investing service, such as Wealthsimple. Follow these steps to open an account:

  1. Make sure you're eligible according to the Roth IRA income limits.
  2. Choose a bank or broker, and fill out all the paperwork. Alternatively, you may open an account online.
  3. Choose your investments. You can even let a broker or robo-advisor choose for you.
  4.  Set up your monthly or yearly contribution schedule. 

It’s that simple.