A Roth IRA is an Individual Retirement Account that you can contribute after-tax dollars to (i.e., money from your paycheck).
It’s important to understand that a Roth IRA is a type of account. It is not a type of investment. So if you open a Roth, you need to invest in funds within your account. It can be a common mistake to put money into a Roth, which is really just an account and forget to actually invest those funds.
The Advantages
Unlike the money that you may contribute to your 401(k) that gives you a tax advantage now, a Roth gives you the tax benefit later in your life. The Roth allows what you contribute and your earnings to grow tax-free, AND you can withdraw them tax- and penalty-free after age 59 1/2. There are a lot of other awesome advantages:
- Withdraw contributions anytime. You can withdraw your contributions at any time. So if you contribute $6,000 during the year and your money grows to $9,000. You can withdraw that $6,000 at any time, but not those $3,000 in earnings.
- No contribution age restrictions. You can contribute at any age as long as you have a qualifying earned income. Meaning, if your 10 year old earns an income (i.e., has a job that earns income, like babysitting or a paper route), they can open up an account.
- No Required Minimum Distributions (RMDs). There are no mandatory withdrawals, allowing your savings to continue to grow even during retirement. With a 401k, RMDs must be taken starting at age 72.
- No income taxes for inherited Roth IRAs. If you pass your Roth IRA onto your kids or grandkids, their withdrawals will also be income tax-free.
The Disadvantages
Of course, every investment decision has its advantages and disadvantages. There are a few disadvantages with this type of account.
- Pay taxes now. You pay taxes upfront. It can be hard to take the tax hit now, especially if you are already struggling to save.
- You have to set it up yourself. Unlike a 401k that your employer sets up and often enrolls you in, you have to set up the Roth account yourself and also remember to fund it. Setting up automatic contributions can make this process a lot easier.
- Income limits. If your income is higher, you may not be able to contribute to the Roth (at least not directly). Eligibility is based on your modified adjusted gross income (MAGI).
- In 2021, single tax filers must have MAGI of $140k or less to be able to contribute
- In 2021, married and filing jointly must have MAGI of $208k or less to be able to contribute
The Power of Maxing It Out
Now that we have evaluated the pros and cons, let’s look at some real examples. The chart below shows the impact that starting young can have on reaching financial independence.
Starting at age 23 and maxing out the $6,000 contribution every year until the age of 65 would leave you with just over $3.5 million dollars!
Starting just seven years later at age 30 and doing the same, will leave with you close to $1.8 million.
How to Open it
There are a lot of options in terms of where you can open up a Roth IRA. Every major brokerage (Charles Schwab, Fidelity, Vanguard, Wealthfront, etc.) will have one to choose from. So it really comes down to selecting a brokerage that has good funds to choose from for picking where you want to invest the money within the account.
I love Vanguard, because they have my favorite index fund options. So we chose to open up both of our Roth IRA’s through them and invested the money into VTSAX.
I actually hesitated on opening this account up for many years, because I was stuck in analysis paralysis about where to open up an account, and I was confused about how to open it in general. So in case this is helpful for someone, I will walk you through the exact steps of how I opened this up:
Step 1: Once I decided to go ahead with Vanguard, I navigated to their website and searched for “Roth IRA.” Click on the button “Open Your IRA Today.”
Step 2: Since I was opening a new account, I clicked on the button “Start your new account.”
Step 3: If you are going to be contributing to the account using money from your bank account select the option that says “electronic bank transfer or other vanguard account.”
Step 4: At the time, I didn’t have an account so I selected the option “No. I’m new here” to first create an account.
Step 5: Select the account type you want to open. Make sure you select “Retirement (IRAs) and then “Roth IRA.”
Step 6: You will need to fill out the fields to tell them about yourself. Once that is filled out it will bring you to the next page to include information about your mailing address and contact information.
Once you fill out the information, it will take between 24-48 hours for them to verify your account.
Step 7: While you wait for your account to be verified, you can look at the different funds you are able to purchase.
Navigate to the investing tab at the top the home screen and you will find options to look at their mutual funds, ETFs, bonds etc. If you are unsure of where to start, I think that low cost index funds are the bees knees and my favorite choice for long term investing.
In particular, my fund of choice is the Vanguard Total Stock Market Index Fund (VTSAX).
This fund is designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks. The fund’s key attributes are its low costs, broad diversification, and the potential for tax efficiency. Essentially, you get a small piece of every major public company in the US.
Step 8: Once you have decided which fund(s) you want to invest in within your Roth IRA account, you will want to log into your account, and navigate to the “My Accounts” page and click on “buy & sell.”
From there, select “Buy Funds.” Then type in the fund you would like to purchase, either by entering in the name or ticker symbol. You can then purchase the amount in dollars of how much you would like to buy. For VTSAX, it requires a minimum investment of $3,000. Other funds have different minimum investments.
From there, the last step is simply choosing which account the money is coming from (like your checking or savings account).
That’s it! You have set up your account and selected the funds you want to purchase within the account. You are now on your way to setting yourself up for a bright financial future.
You can contribute up to $6,000 per year. You can choose to either do it in lump sums or set up automatic contributions on a monthly basis. Overall, the most important part is just getting started.
I’d love to hear from you. Do you currently use a Roth IRA as a vehicle for your investments?
