A Roth IRA is one of the most powerful investment tools you have access to. It can allow you to earn hundreds of thousands if not millions of dollars tax-free. It is important, however, for beginners to understand how the Roth IRA works. In this Roth IRA beginners guide, we will be teaching you everything you need to know about investing through a Roth IRA retirement account.
If you aren't familiar with the excellent benefits of the Roth IRA, let's go ahead and start there. We will go into far more detail later on.
A Roth IRA is a type of retirement account that allows your money to grow tax-free.
Most people are familiar with 401(k) accounts through their employer, but not so much IRA accounts (individual retirement accounts). Both of these accounts are unique, and in many cases, it makes sense to have both a pretax retirement account and a post tax retirement account.
Unlike the traditional IRA or 401(k), the Roth IRA is funded with post-tax income.
As a result, your money then grows 100% tax-free. Those who maximize their Roth IRA contributions at an early age, potentially have the opportunity to become a tax-free millionaire by the time they reach retirement age.
Check out this video by Ryan Scribner, one of the blog authors, to learn more:
How Does A Roth IRA Work?
The best way to understand how a Roth IRA works is to look at the concepts of instant gratification versus delayed gratification. Investing through your 401(k) gives you instant gratification in the form of a tax write off. You contribute to a traditional retirement accounts with pre-tax income meaning, the contributions reduce your taxable income. Down the road, you will have to pay taxes when you draw from the traditional IRA or 401(k). If you take money out early, unless it is for a few specific cases, you will pay a hefty penalty and taxes. Ouch!
The Roth IRA, on the other hand, is delayed gratification. You are investing money you already paid taxes on. As a result, there is no immediate benefit. No, write off. No trophy, not even a cookie. However, once you draw from the Roth IRA (assuming you follow the rules outlined later), you do so tax-free and penalty free. On top of that, you can withdraw your contributions from a Roth IRA at any time penalty-free and tax-free if your account has been open for at least 5 years. You just can't touch the earnings.
With a traditional IRA or 401(k), all of the benefits are on the frontend (instant gratification) versus the backend (delayed gratification) benefits of the Roth IRA/ 401(k). We will explain this in more detail later, but in most cases, it actually makes sense to contribute to both a pre-tax (IRA/401(k)) and post-tax retirement account (Roth IRA/401(k)). Both have unique benefits that savvy investors can take advantage of.
The Benefits Of A Roth IRA?
There are several benefits associated with investing in a Roth IRA. While most are tax-related, not all are. The Roth IRA allows a method of retirement savings without locking up your money. It also can be a way for you to leave money for your loved ones when you do pass on. Let's break it all down!
1. Tax-Free Retirement Income
The first benefit, which we already discussed, is the tax-free retirement income. Anyone with earned income can begin contributing to a Roth IRA. As long as you are within the income limitations, you can maximize your contribution year after year. Once you reach the retirement age, which is currently 59-1/2 years old (because we all celebrate half birthdays, right?), you can begin withdrawing the earnings tax-free. Remember, you can withdraw contributions at any time and any age penalty free!
2. No Required Minimum Distributions
Retirement is for some people, but it isn't for everyone. Maybe you want to continue to work into your 60's or even your 70's. If that is the case, you might want to continue contributing to your retirement savings as well. Or, you at least don't want to touch that money yet. The Roth IRA has a huge benefit that the Traditional IRA does not have, and it comes down to required minimum distributions.
At age 72, the IRS requires you to start taking distributions from your Traditional IRA and begin paying taxes as well. Regardless of whether you need the money or not, you have to start drawing from the account.
The Roth IRA is different! There are no required minimum distributions. This means that you do not have to take money out at any time. It also means that you can continue contributing to the Roth IRA, so long as you have earned income. If you want to be an ambitious 80 year old and continue working, you can keep on contributing!
3. High-Income Loophole
We will go into more detail about this later, but there is a loophole called a Backdoor Roth IRA that allows high-income earners who exceed the income limitations for a Roth IRA to contribute anyway. For 2020, the income limits are $139,000 for single filers and $206,000 if you are married filing jointly. If you make less, you can contribute to a Roth IRA directly. If you make more, keep reading! We will explain the Backdoor Roth IRA later.
4. Access To Contributions
If you aren't sold on the Roth IRA yet, here's one of the most significant benefits. Since you are contributing your post-tax income, you can withdraw your contributions at any time tax and penalty free, as long as your account has been open for at least 5 years. When you invest, you have both contributions and earnings. Contributions are the money that you are putting in. Profits are, well, the money you earn as your investment grows!
Let's go over a quick example. John, age 30, invests $5,000 per year for 5 years in a Roth IRA. Then, John decides he wants to buy a house. His Roth IRA currently has a balance of $30,000. Of that balance, $25,000 is what he contributed, and $5,000 is what he earned. John can withdraw that $25,000 tax and penalty free for his home purchase and leave the remaining $5,000 to continue growing. If John pulls out that $5,000 in earnings, he will pay taxes and penalties on the earnings.
5. Estate Planning
Remember how we talked about those pesky required minimum distributions? Well, we already know that the Roth IRA does not have required minimum distributions, but this comes with another added benefit. This makes the Roth IRA a fantastic tool for estate planning.
For those who are not familiar, estate planning is anticipating and laying out plans for when you pass away. Your Roth IRA is passed right along to your heirs tax-free and penalty free. As long as they meet required criteria, the Roth IRA continues to grow tax-free. With the Traditional IRA, the account starts to drain after 72 years old thanks to those required minimum distributions (RMD). With the Roth IRA, you can pass money through to your heirs without taxes, penalties, or distributions needed of any kind as you age.
When your beneficiary inherits the account, they may need to begin taking Roth IRA RMDs on the account.
The next benefit of the Roth IRA is that you have complete freedom over where you open one and what you put in it. With the 401(k), you are stuck with whoever your employer works with, and whatever that plan offers. In some cases, this could be high fee mutual funds that are just not an appealing investment.
You can open a fee-free Roth IRA with M1 Finance or get hands-on guidance from Betterment for just 0.25% annual asset management fee. M1 Finance allows you to pick and choose your stocks or ETFs that you want to include in the Roth IRA portfolio. Betterment invests your money in high-quality ETFs with some of the lowest expense ratios in the industry.
7. Home Purchase
You are allowed to withdraw earnings from your Roth IRA if you are under the age of 59-1/2 as long as that money is going towards your first time home purchase. The maximum amount of earnings you can withdraw is $10,000. This makes the Roth IRA a great place for investing money earmarked for a first time home purchase.
Who Is Eligible For A Roth IRA?
To invest directly in a Roth IRA, you have to meet a few requirements. Remember, if you exceed the income limits you can always follow the Backdoor Roth IRA strategy which we will discuss later on! These requirements are put in place by the IRS. You need to be a US Citizen with a US Address and Social Security Number. Beyond that, here are the requirements.
These requirements are for the 2020 tax year. We will do our best to update them, but you should always check with the IRS website or consult with a tax professional for the most current information.
If you make less than $124,000 as a single filer or $196,000 as married filing jointly, you can fully contribute to a Roth IRA. For those making more than $139,000 as a single filer or $206,000 as married filing jointly you cannot directly contribute to a Roth IRA. If you fall in between these figures, use this calculator to see how much you can contribute.
Where To Open A Roth IRA?
One of the benefits to the Roth IRA that we discussed earlier is that you can open one wherever you want! There are many brokerages and investment firms offering Roth IRAs, but we want to make two recommendations specifically. It is crucial to choose the right brokerage or firm to work with, as it could potentially save or cost you tens of thousands of dollars over the lifetime of the account.
#1 Pick: M1 Finance
Our first place pick for opening a Roth IRA is M1 Finance. This is a cutting edge brokerage account that is offering 100% fee free retirement accounts. You can read our full review of the M1 Finance Roth IRA for more details, but we will give you the footnotes here.
M1 Finance offers retirement accounts, including the Roth IRA, for a minimum balance of just $500. Through M1 Finance, you have many investment options. First of all, you can build your own custom portfolio from scratch with whatever stocks or ETFs you would like to invest in.
Or, you can invest in one of the Expert Pies being offered by M1 Finance. These are portfolios built by leading financial experts, offered completely free! This includes TDFs or target date retirement funds, an ideal pick for a Roth IRA. These funds automatically change the allocations as you age to ensure that you are not too conservative or aggressive with your investments. As of now, M1 Finance is the only brokerage out there offering 100% fee free retirement accounts.
#2 Pick: Betterment
Our runner up for opening a Roth IRA is Betterment. For those who do not want to build a portfolio from scratch, this could be a perfect option. Most financial advisors out there charge a 1% annual asset management fee to manage your investments. Betterment is a roboadvisor, meaning it is technology driven. The savings are passed along to you in the form of a 0.25% annual asset management fee. With Betterment, you will be getting a 100% customized portfolio tailored to your specific needs and investment goals.
Beyond that, Betterment will take care of rebalancing and reallocating your portfolio as time goes on. You can also take advantage of a feature Betterment offers called the Tax Coordinated Portfolio, which has resulted in some serious tax savings for Betterment investors. According to the Betterment website, this strategy can boost after-tax returns by an average of 0.48% each year, meaning Betterment has the potential to pay for itself! Betterment has no minimum balance to open a retirement account with them.
How To Open A Roth IRA?
If you are ready to get started, the process for opening a Roth IRA is pretty simple. If you prefer video instruction, here is a video Ryan Scribner, one of the blog authors, put together:
Step 1: Determine if you are eligible for a Roth IRA.
The first step is to determine whether or not you are eligible for a Roth IRA in the first place. We covered this earlier, but the income limits set by the IRS for 2020 are $139,000 for single filers and $206,000 for married filing jointly. If you fall below these requirements, you are good to go! If not, skip ahead to the section on the Backdoor Roth IRA.
Step 2: Decide where to open a Roth IRA.
One of the many benefits to the Roth IRA is that you can open one wherever you want. Our recommendation for a fee-free Roth IRA is M1 Finance. If you are looking for a little bit more guidance with your money, Betterment offers automated portfolio guidance for just 0.25% annual asset management fee. You can also open a Roth IRA with an in-person financial advisor, but it will likely come with a significantly higher asset management fee.
Step 3: Collect the needed information.
The IRS requires the following information to be collected when opening an investment account:
- Photo Identification (License or Passport in most cases)
- Social Security Number
- Bank Routing/Account Number (To fund the account)
- Your Information (Name, Address, Contact Info)
- Your Employers Information (Name, Address)
- Annual Income/Net Worth
- Investment Objective/Risk Tolerance
- Brokerage Affiliation (Do you/a family member work for a brokerage)
Step 4: Decide what to invest in.
The next step is to decide what to invest in within your Roth IRA. If you go the self-directed route, you can pick and choose you your investments. This could be stocks, ETFs, or a combination of both! There are even ways to invest in Bitcoin and other cryptocurrencies within your Roth IRA if you choose to do so. If you don't want to be a hands-on investor, you can follow the passive strategy and invest in a portfolio of mutual funds or ETFs.
Step 5: Fund or transfer to the account.
The next step is to fund the account. You can maximize your Roth IRA contribution all at once or make contributions throughout the year. Another option is to roll over another retirement account to this Roth IRA. We will discuss this in greater detail later on.
Step 6: Contribute each year.
This step is optional, but it will give you the most significant benefit with your new Roth IRA. By contributing each year, or even better maximizing your contributions, you are shelling away more money that will experience tax-free growth. You can contribute to a Roth IRA anytime from January 1st to April 15th of the following year, giving you a 15-month window. For example, for the 2020 tax year, you could fund the Roth IRA anytime from January 1st, 2020 to April 15th, 2021, and it would count as your 2020 contribution.
Roth IRA Contribution Limits
If you meet the income requirements, here are the contribution limits:
$6,000 (under age 50*)
*If you are over age 50 you get a $1,000 catch-up contribution, making your total eligible contribution $7,000.
These contribution limits are for the 2020 tax year. You should always check with the IRS website or consult with a tax professional for the most current information.
It is pretty straightforward! Anyone with earned income can contribute to a Roth IRA, so long as they don't exceed the income limit. If you are under 50 years old, you can contribute $6,000. If you are 50 or older, you can take advantage of a catch-up period and contribute up to $7,000.
Roth IRA Taxes And Penalties
With a Roth IRA, you are contributing post-tax income. There are no tax breaks or tax benefits associated with a Roth IRA. Contributions to your 401(k) can be used to lower your taxable income. This is not the case with the Roth IRA. Since you already paid taxes on them, you can withdraw your contributions at any time penalty free.
There are two requirements you have to meet to withdraw earnings tax and penalty free:
- You are 59-1/2 or older.
- You have had the Roth IRA for more than 5 years.
If you are over 59-1/2 and you withdraw earnings from a Roth IRA that you have had for less than 5 years, you will pay taxes but not penalties. If you are under 59-1/2 and you withdraw earnings at any time, you will pay taxes on the earnings and a penalty of 10% of the total distribution. Talk about a slap on the wrist!
There are a few other uncommon cases where you can withdraw from a Roth IRA penalty-free. You will still have to pay the taxes. This includes using the money to pay for qualified education expenses, medical bills, or health insurance if unemployed. There are also some cases where if you become disabled or pass away, you may not have to pay the penalty.
When Can You Contribute?
You can contribute to a Roth IRA at any time from January 1st to April 15th of the following year. This gives you a 15-month window for when you can make your contributions. For example, in 2020, you can contribute to your Roth IRA anytime from January 1st, 2020 to April 15th, 2021. Some people contribute each month throughout the year, following an investment strategy known as dollar cost averaging. Others will maximize their entire contribution right at the beginning of January, so they don't forget!
What To Invest In?
So now that you have this Roth IRA, what should you be investing in? With a Roth IRA, you have a lot more control over what you invest in. First of all, let's start out with a list of what you can invest in:
- Stock Mutual Funds/ETFs
- Bond Mutual Funds/ETFs
- Individual Stocks
- Certificate Of Deposit
- Gold/Precious Metals
If you are a hands-on investor who wants to build a portfolio from scratch, M1 Finance allows you to hold any stocks or ETFs you want within your portfolio. Gone are the days of boring mutual fund retirement investments. If you wish, you can hold technology stocks like Microsoft or Apple!
For those looking for a more hands-off approach, you can go the managed route. Betterment offers fully managed portfolios for an annual asset management fee of just 0.25%. You do not need to worry about asset allocation or rebalancing your portfolio. They take care of the entire process for you!
Ultimately, what you invest in within your Roth IRA is totally up to you! It all depends on your investing style and whether or not you want to be actively involved with your investment. What you won't find in a Roth IRA are penny stocks that don't trade on major exchanges. These penny stocks do not make for proper long term investments in most cases.
Roth IRA vs. Traditional 401(k)
The Roth IRA and 401(k) are closely related in terms of the benefits they provide. As mentioned earlier, in most cases, it makes sense to use both! There are several key benefits to the Roth IRA, however. Here are the benefits to investing in a Roth IRA:
- With a Roth IRA, you can allow your money to grow tax-free.
- A Roth IRA allows greater flexibility as you can invest in whatever you want.
- You can withdraw Roth IRA contributions at any time, tax and penalty free.
- Roth IRA earnings can go towards the purchase of your first home.
Now, there are some benefits to the 401(k) as well. A 401(k) is something offered by your employer. You can take a portion of your paycheck and put it towards your retirement. And yes, you can have both a 401(k) and a Roth IRA. Here are the benefits of using a 401(k):
- Some companies offer a matching dollar for dollar.
- Contribution limits are higher.
- You can lower your taxable income by making contributions.
- There is no income limit on the 401(k).
Company Match Example
In a nutshell, this strategy makes sense for most people. Remember, we are not financial advisors, and this is not to be mistaken for financial advice. You should always consult with a financial professional as each situation is different.
When I worked at my day job, I was offered a Vanguard 401(k), and the company provided a match program. They would match my contributions at 50% up until 6%. This meant that if I contributed 6% of my pre-tax income to my 401(k), they would give me an additional 3%. If I contributed 10%, it would still just be 3% that they would contribute.
I earned a salary of around $65,000 per year, meaning that my 6% contribution was $3,900. My employer chipped in an additional 3%, or $1,950. This was 100% free money. As a general rule of thumb, you should never turn down free money! If you saw a $100 bill on the sidewalk, you would pick it up. The same concept applies here.
The Problem With 401(k)'s
Not all 401(k)'s are created equally. Some of them are great. They are managed by a great provider like Vanguard or Fidelity, and they hold low fee index funds or mutual funds. Others, well, not so great. They are loaded with fees. Unfortunately, as we mentioned earlier, you are stuck with whoever your employer decides to work with. If you are in doubt, do some research on your 401(k) provider. Here is a list of the best 401(k) plans.
Backdoor Roth IRA
A backdoor Roth IRA is how you can get around the income limitations that are in place. As we mentioned earlier, you can't directly contribute to a Roth IRA if your income exceeds the limit. There is a simple workaround, however. Instead of contributing to a Roth IRA, you contribute to a Traditional IRA. Then, you convert that Traditional IRA to a Roth IRA. Based on current laws, which could change eventually, anyone can convert a Traditional IRA to a Roth IRA regardless of their income.
There is another loophole to this that does not make much sense either. You are allowed to convert a Traditional IRA to a Roth IRA regardless of how much is in the account, even if it exceeds the contribution limit! This is one of the ways of getting around those contribution limits.
Now, it is essential to keep in mind that there are some tax consequences associated with this move. Since you are moving from a pre-tax account, the Traditional IRA, to a post-tax account, the Roth IRA, you have to pay taxes. Another issue to look out for is that this move might push you into a higher tax bracket, as the taxable amount that is converted is added to your total income.
Traditional IRA/401(k) Conversion to Roth IRA
Another option you have for funding a Roth IRA is doing a rollover. If you have an old 401(k) that you want to use to fund a Roth IRA, you can do precisely that. One caveat is you need to make a pit stop in between at the Traditional IRA. Mostly, it goes something like this. You roll over your 401(k) to a Traditional IRA, this transfer is not a taxable event. Then you convert the Traditional IRA to a Roth IRA and pay the tax bill. Both M1 Finance and Betterment have services in place to help you with the rollover process.
One important rule to note is that most employer sponsored 401(k) plans do not allow in-plan rollovers. You must retire or no longer work for the company in most cases to roll your 401(k) out of the plan.
Roth IRA: The Verdict
The Roth IRA is one of the most powerful tools you have in front of you for building your wealth. Those who take advantage of it are able to, in some cases build million dollar portfolios that are entirely free of the tax burden. Understanding how this investment account works and what options you have in front of you is crucial to taking full advantage of the Roth IRA.