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This morning on our walk, Eve, our 22-year-old nanny, said the seven magical words I've been waiting to hear her say since she first asked me about the stock market last summer...

"I think I'm ready to start investing."

Suddenly, the sun burst through the clouds. Birds started singing in the trees around us. Bells rang out from who knows where.

"Cool," I said, pushing down the sudden urge to start singing about the magic of compounding returns. (Yes, I'm a nerd about personal finance, but at least I'm self-aware.) "Why do you want to invest? What's the goal?"

"I want my money to grow. A lot. I want to be a millionaire when I retire."

I smiled because I knew the next part would surprise her.

"Actually, that's a lot easier than you think, especially if you start now. Let me tell you about this crazy thing called a Roth IRA..."

Plant a Seed, Watch It Grow

Investing for retirement is like growing a tree. If you plant a seed in your twenties, you'll have a great big oak when you're 60.

And one of the most popular places to plant that seed is an Individual Retirement Account (IRA).

IRAs are designed to help you save and invest for the long term, with the added bonus of some serious tax advantages. Essentially, an IRA acts as a personal retirement savings plan, but with specific rules and incentives that make it more beneficial than a standard savings account.

Another big difference between IRAs and standard savings accounts? Most IRAs allow you to invest in stocks and bonds, which means your money can grow — a lot.

How much? Well, that's exactly what Eve wanted to know.

In her case, she wants to start putting $500/month into her retirement plan. If she keeps up that monthly contribution and puts it into investments that grow 10% annually, she'll have $2.3 million when she's 60. Mission accomplished!

A Tale of Two IRAs

IRAs come in two main types — Traditional and Roth. While there are a few important differences between the two, the biggest is how they're taxed.

Traditional IRA: Contributions are tax-deductible, so you're not paying taxes on the money going into the account; however, when you retire and start withdrawing money, those withdrawals are taxed as normal income.

Roth IRA:These contributions are NOT tax-deductible. But because you paid taxes on the money when it went into your account, your withdrawals are tax-free when you retire.

In other words, with a traditional IRA, you pay taxes on the tree. With a Roth, you only pay taxes on the seed.

Let's go back to our theoretical $2.3 million retirement tree. In our example, we got there by contributing $500/month to our IRA every month from age 22 until age 60, or 456 months. In total, our contributions add up to $228,000.

If you plant your seed in a Roth IRA, your contributions won’t be tax deductible. That means you’ll have paid some tax on this amount when you file your taxes each year. If we assume the highest tax rate currently possible (37%), that tax adds up to $84,360. But your withdrawals from this account during retirement would be entirely tax-free. This means every cent of your $2.3 million could be used without worrying about tax deductions.

Now, consider the same scenario with a traditional IRA. If you grew your $2.3 million tree in this type of account, each withdrawal in retirement would be subject to taxes just like normal income. Even at a modest tax rate of 25%, if you withdrew all $2.3 million of it over the course of your retirement, your total tax bill would be about $570,000.

This substantial tax burden could significantly reduce the amount of money available to you each year, impacting your retirement lifestyle and financial security.

Is a Roth IRA Right for You?

For her goals and current financial circumstances, a Roth IRA is the perfect choice for Eve. But is the right choice for you?

When determining if a Roth IRA suits your needs, consider the following factors...

Income Limits:Roth IRAs have income restrictions. In 2024, you must make less than $146,000 as an individual ($230,000 if you're married) in order to fully contribute to a Roth IRA. If your income is higher than that, you're ineligible (although you can still contribute to a normal IRA). However, methods like a backdoor Roth IRA can allow people with higher incomes to enjoy the benefits of a Roth, but due to their complexity, you'll want to consult with a financial advisor before attempting one.

Contribution Limits: It's important to note that IRAs have annual contribution limits. For 2024, you can only contribute up to $6,000 per year, or $7,000 if you're age 50 or older. If you're looking to significantly increase your retirement savings in a short period, this limit may restrict your ability to do so (compared to other retirement accounts that have much higher contribution limits). You can, however, contribute to IRAs in addition to your other retirement accounts.

Tax Rates:Your current and expected future tax rates are crucial in deciding whether you should contribute to a Roth IRA. If you predict higher taxes in retirement, a Roth IRA can lock in your current lower rate.

Withdrawal Flexibility:Unlike Traditional IRAs, Roth IRAs do not have required minimum distributions, allowing your money to continue growing tax-free indefinitely.

Early Access to Funds:Roth IRAs permit you to withdraw your contributions (not earnings) at any time without penalty, providing flexibility for unforeseen expenses.

Estate Planning:Beneficial for estate planning, Roth IRAs ensure your heirs can inherit and withdraw funds tax-free.

Young Investors:Roth IRAs are particularly appealing for young investors who expect their income and tax rates to rise over time, maximizing the benefit of tax-free growth.

Think of a Roth IRA like a piggy bank that turns every penny into two, tax-free, by the time you need it for retirement. For Eve, and maybe for you too, it's the financial hack that turns early and consistent saving into a lush retirement forest — no tax axe required.

If you're wondering whether a Roth IRA is right for you, chat with a financial advisor who can help align it with your goals and financial landscape. Here's to growing your financial future!