Roth IRA: What is it and why do you need one?

Saving for retirement might not be a top priority when you’re in your 20s, but talk to any finance expert, and you’ll hear that it should be.

“Just get started,” says John Anderson, president and founder of Cypress Wealth Management in Germantown, Tennessee.

Putting away $100 a month now could make a huge difference in how financially stable — or unstable — you’ll be when you retire. And a Roth IRA (short for individual retirement account) is a great way to do it. Here’s how to turn the price of one Starbucks latte a day into big savings by the time you’re ready to put your working days behind you.

Your Guide to Roth IRAs

• Roth IRA: What It Is and Why You Need It
• What Can I Do With My Roth IRA Money?
• How to Open a Roth IRA

What is a Roth IRA?

Roth IRAs are named for former Delaware senator William Roth, who pushed for their creation in the Taxpayer Relief Act of 1997. A Roth IRA is a retirement savings account that you contribute to after taxes have already been taken out of your income. When you take money out of the account in retirement, you won’t have to pay taxes on what you’ve contributed or earned in investment returns. This makes it different from a “traditional” IRA, in which you can make contributions with pretax dollars, but you pay income taxes on withdrawals later on.

Using a Roth IRA is especially smart for young people because you’ll probably be in a higher tax bracket when you retire than you are today. So you’ll avoid a larger tax bill later if you opt to be taxed now, when you’re making less money.

How much can I put into a Roth IRA?

You can contribute up to $5,500 a year to a Roth IRA, as long as you have income from work. (People age 50 and older can add an extra $1,000 a year.) The exact amount you can kick in to your account depends on Opens a new windowhow much you make each year. The limits are typically adjusted every few years.

For instance, as a single person you can contribute the maximum amount of $5,500 if you earn $116,000 or less annually. You can’t contribute to a Roth IRA at all if you earn more than $131,000 a year. Also, if you make less than $5,500 a year, you can’t contribute any more than what you earned from work. (That means you couldn’t move additional money in from savings or have someone else add to your account on your behalf to bump you up to $5,500.)

Turn the price of one Starbucks latte a day into big savings by the time you’re ready to put your working days behind you.

The magic of a Roth IRA lies in compounded earnings. The money you earn on your investments each year gets added back into the account balance, so the next year you have a higher amount earning returns. If you invest an initial $50 in a Roth IRA and add $50 every month at an 8% annual return (the 10-year average of the stock market’s growth), you’d have $156,520 by 2055.

In 40 years, you’d have contributed $24,000 in total, so the rest — a whopping $132,520 — would be from compounded earnings. Use a Opens a new windowcompound interest calculator to see the power for yourself.

How is it different from other retirement plans?

A 401(k) plan is another popular retirement savings option, but it’s employer-sponsored, meaning you’re only able to contribute through your workplace. Unlike in a Roth IRA, your contributions to a 401(k) are tax-deferred. That lowers your taxable income at the time of contribution, but you pay income taxes on your withdrawals. You’re also limited in when you can withdraw money from a 401(k). If you dip into your account before you turn 59½, you may have to pay a 10% penalty, plus income taxes. Yikes.

Unlike a 401(k), a Roth IRA is “individual” — you can set it up and choose a provider on your own. It’s more flexible than a 401(k), which you’re required to withdraw from by the time you turn 70. You can even leave your money in a Roth IRA untouched and bequeath it to your kids.

Now that you’ve got all the basics covered, check out how you can make the money in your Roth IRA work for you.

Brianna McGurran is a staff writer at NerdWallet, a personal finance website. Email: [email protected]. Twitter: @briannamcscribe.

This article originally appeared on NerdWallet.