What is a Roth IRA? A Roth IRA is one of the most powerful investment tools you can utilise. It can allow you to make thousands of dollars tax free if used correctly. For beginners it is very important to understand how a Roth IRA works, so in this guide I will teach you everything you need to know about investing through a Roth IRA retirement account. Read this article very carefully and check out our other article for The Best 6 Ways you Can Invest $100.
If you aren’t familiar with the benefits of the Roth IRA, I will start here. We will go into more detail further on but here is a small breakdown. A Roth iRA is a type of retirement account that allows your money to grow tax free. Most people are familiar with the 401K but not the Roth IRA. Both of these accounts are unique, and in most cases it makes sense to have both if you are eligible. The big difference between these accounts is the Roth IRA is funded with post-tax income, the 401K is pre-tax income. Because you have already paid tax on the income, you can now grow your Roth IRA 100% tax free. People who are able to maximise their contributions into Roth IRA have the potential to become tax free millionaires by the time of retirement.
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 against delayed gratification. Investing in a 401K will give you instant gratification in the way of a tax write off, you are contributing pre-tax income and therefore lower your taxable income for the year. When you come to retirement, you will have to pay tax on the money you withdraw from the 401K. Also if you decide to take it out early, unless you meet very specific criteria you will be served a huge penalty on top of the tax you need to pay.
With the Roth IRA you will get delayed gratification. You are investing money you have already paid tax on, and therefore don’t receive any initial benefit like a tax write off. But the upside is, once you draw the money from the Roth IRA, making sure you follow the rules I will outline later, you are drawing money that is tax and penalty free!
A 401K has all the benefits upfront, and they are easy to understand, however you need to look long term when investing money. So waiting for delayed gratification can sometimes be the better option. However like I mentioned before, having both a 401K and a Roth IRA makes sense as both have useful advantages that savvy investors can exploit.
7 key benefits of a Roth IRA
#1. Tax free retirement income
The first benefit, which we have already discussed, is the tax free retirement income. Anyone with earned income can open and contribute to a Roth IRA. As long as you are within the income limitations, you can maximise your contribution year after year. Once you reach retirement age you can begin withdrawing the earnings tax free, but remember you can withdraw contributions you’ve already made at any time without penalty.
#2. No required minimum distributions
For a lot of people retirement doesn’t appeal to them, maybe you want to work until you’re 70, 80, or even longer. If this is the case, you might want to continue contributing to your retirement savings until you’re 70, 80, or even older. With traditional IRA’s this is not possible. At the minute, once you hit the old age of 70+½ the IRS requires you to start taking distributions from your traditional IRA. You are no longer allowed to contribute at this point, you have to start drawing.
The Roth IRA is very different. There are no restrictions on when or how much money you have to draw. It also means you can continue to contribute as long as you have an earned income. So if you want to keep working until you’re 100 go for it!
#3. Access to contributions
You should be sold on a Roth IRA by now, but if you’re not here is one of the most significant advantages of investing in a Roth IRA rather than a traditional, 401K, or most other things on the market.
Since you are contributing post tax income, you can withdraw your contributions whenever you want, with no tax to pay, no penalties, and no admin fees! When you invest in a Roth IRA, you have contributions and earnings. Contributions being what you put in, and earning being the interest that your contribution earns.
A quick example is if I was to invest $10,000 per year into a Roth IRA for 5 years. 5 years later I decide I want to buy a house, my current balance in my Roth IRA is $60,000. Of that balance, $50,000 is what I contributed, and the remaining $10,000 is what I earned in interest. That gives me $50,000 that I can withdraw tax and penalty free, leaving $10,000 to continue growing.
#4. Estate planning
Most retirement plans or accounts have a required minimum distribution as we have mentioned. As we know with a Roth IRA you don’t have to take your money if you don’t want to. This makes them great tools for estate planning.
If you’re not sure what estate planning is, it is basically a plan you are laying out for when you die. With a traditional IRA the funds start to drain when you reach 70+½. However with a Roth IRA, you can leave your contributions and earnings in the account and pass them on to your family when you pass away (tax & penalty free!). Then your family can contribute and continue to grow the balance of your Roth IRA for generations.
#5. High income loop-hole
There is such a thing called a Backdoor Roth IRA, which we will go into more detail later on. If you are a high-income earner who exceeds the income limitations for a Roth IRA you can use a Backdoor Roth IRA to contribute. For 2019, the income limits for a single earner was $137,000, and more married couples who file jointly the limit for 2019 was $203,000. If you earn less than these figures you can contribute directly, but if you are lucky enough to earn more, then keep reading!
#6. Home purchase
The only time you are allowed to withdraw the earnings of your Roth IRA when you are under the age of 60 is if the money is going towards your first time home purchase. The maximum withdrawal of earnings you can take is $10,000.
The freedom you get by investing in a Roth IRA is non parallel to the other options on the market, you have complete control from you moment you open one, you decide where you open one and how much you want to invest. If you choose a 401K you are stuck with the provider your employer chooses and you have to abide by the rules on the plan they offer. In some cases this is a high fee mutual fund that is not an appealing investment.
You can open a fee-free Roth IRA with M1 Finance or, for an annual asset management fee of 0.25% you can open a guided account with Betterment. M1 Finance allows you to pick and choose the stocks and ETF’s that you want to include in your Roth IRA portfolio, you can change and control your balances at any time as well. With Betterment, your money is invested in high-quality ETF’s and the earning goals are based on the preferences you choose, this can sometimes be more risky as you don’t have knowledge of which funds Betterment is investing in.
Who is eligible for a Roth IRA?
You have to meet certain criteria before you can invest in a Roth IRA, but these requirements are meant to suit the majority of people. Also remember, if you exceed the income limits you can always follow the Backdoor Roth IRA strategy that we will discuss soon! The main requirements are put in place by the IRS. You need to be a US Citizen with a US address and Social Security Number. Other than that, here are the requirements.
These requirements are for the 2019 tax year. We do our best to update content but you should always check on the IRS Website or consult your accountant for the most current information.
What is a Backdoor Roth IRA?
If you make less than $122,000 as a single filer, or $193,000 as a married couple filing jointly you can fully contribute to a Roth IRA. For people earning more than $137,000 as a single filer or $203,000 as a joint filing you cannot directly contribute to a Roth IRA. If you fall between these figures you will need to use this calculator to see how much you can contribute per year.
If you earn over the income limits that are in place don’t worry, there is a simple workaround. However, instead of contributing to a Roth IRA, you contribute to a Traditional IRA. Then, you can convert your Traditional IRA into a Roth IRA based on current legislation. Anyone can convert a Traditional IRA into a Roth IRA regardless of their income.
Another great loophole that is associated with the conversion of Traditional IRAs and Roth IRAs is this. Regardless of how much money is in the account, you can convert your Traditional IRA into a Roth IRA, even if the amount exceeds the contribution limits.
With this move there can be some tax consequences. Since you are moving pre-tax income in your Traditional IRA into a post-tax account such as a Roth IRA, you may need to pay tax on the amount you are moving. An addon to this consequence is, if you are converting a large amount of money it may push you into a higher tax bracket so talk to your accountant to iron out the details before setting this loophole in motion.
What exactly can you invest in?
Before you get a Roth IRA you should know the types of investments you can make from within the account. A Roth IRA gives you a lot more control over what you invest in. Let’s run through the 7 securities and commodities you can invest in through a Roth IRA:
- Stock mutual funds (ETFs)
- Bond mutual funds (ETFs)
- Individual stocks
- Certificate of deposit
- Gold and other precious metals
5 Steps to opening a Roth IRA
#1. Decide where to open a Roth IRA
You can open a Roth IRA wherever you want. Our recommendation for a fee-free Roth IRA is M1 Finance, they allow you to have full control over your money and how it is used. If you are looking for a bit more guidance, invest with Betterment, they charge a 0.25% annual fee on the amount in your account if you want advice. You can also open a Roth IRA in person with a financial advisor, but this will most likely come with upfront charges and huge management fees.
A better review of our top recommendations are detailed below.
#2. Collect all the necessary information required
The IRS requires the following information before you can open a Roth IRA:
- Photo ID (Drivers license or Passport)
- Social security number
- Bank account number that you plan on funding the Roth IRA with
- Your personal details such as name, address and contact information
- Your employers name and address
- Your annual income or net worth
- Any investment objectives you might have to assess your risk tolerance
- If a member of your family works for a brokerage you will need to disclose this
#3. Decide what to invest in
The next step is to decide what you want to invest in within your Roth IRA. If you go the ‘do it yourself’ route this can be anything from stocks, ETFs, or a combination of both. There are even ways you can invest in such things as Bitcoin and other cryptocurrencies. If you choose to be more of a passive investor you can leave this step up to your brokerage.
#4. Fund or transfer to your account
The most important step is to actually fund your account. You can maximise your Roth IRA contributions all at once or make contributions throughout the year like I mentioned before. Another option is to roll over another retirement account into a Roth IRA, like we mentioned in the Backdoor Roth IRA.
#5. Contribute each year
This step is optional, but it will give you the most significant benefit with a new Roth IRA. By contributing each year, or better maximising your contributions, you are shelling away more money that will experience tax free growth. As mentioned before you can contribute to a Roth IRA in the 15 month period between January and April of the next year, so don’t be afraid to put your money away.
When can you Contribute?
You can contribute into your Roth IRA at any time from January 1st to April 15th of the following year. That is a 15 month window to make contributions. For example, in 2019, you can contribute to your Roth IRA anytime from January 1st 2019 to April 15th 2020. You can contribute each month, sporadically throughout the year, or maximise your earning by contributing your entire amount in January.
Who Should you Open a Roth IRA with?
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.
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.
M1 Finance also has a feature for the beginner investor, by letting you chose your risk threshold and recommending investment portfolios for you, 100% free and 100% passive.
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.
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.
Roth IRA contribution limits
If you meet all the requirements, and are under the income threshold stated above here are the contribution limits:
$6,000 per year if you are under the age of 50
If you are over the age of 50 you get an extra $1,000 worth of contribution making the total you can invest $7,000 per year. These contribution limits are for the 2019 tax year. You should check the IRS website for up to date information.
If you have trouble saving money check my other article: How to create a monthly budget and stick to it!
Be Careful of Roth IRA taxes and penalties
Because you are investing your post-tax income there are no tax breaks with a Roth IRA, contributions to your 401K can be used to lower your taxable income. Since this is not the case, you have already paid tax on the earnings, therefore you can withdraw your contributions at any time without an unwanted bill or penalty.
There are two major conditions you need to meet to be able to withdraw earnings from you Roth IRA tax and penalty free are as follows:
- You need to be 59+½ or older
- You have had the Roth IRA for 5 years or more
Here are a couple of examples that you will want to note if you don’t meet these conditions. If you are over 59+½ but you have had the Roth IRA for less than 5 years any earnings you withdraw will be subject to tax, but not penalties. Example number two is if you are under 59+½ and had the Roth IRA for more than 5 years, you will pay taxes and penalties on any earnings you withdraw. The penalties will usually be 10% of the total withdrawal.
There are a few cases where you can withdraw from a Roth IRA penalty free, but they will still be subject to tax. These include using the money you withdraw to pay for education expenses, medical bills, or health insurance if you become unemployed.
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.