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What Is a Roth IRA? Rules & How to Open One

A Roth IRA is like your own personal retirement savings pot. You chuck in money from your paycheck after it’s been taxed. Then, whatever you put in and whatever you earn from investments can grow without Uncle Sam dipping into it for taxes. It’s a sweet deal!

What is a Roth IRA account?

A Roth IRA is like your personal retirement buddy. You put in money after it’s been taxed, and then it grows without you owing the taxman a dime. When you hit 59 1/2, and your Roth IRA has been around for at least five years, you can dip into it without Uncle Sam taking a chunk in federal taxes. It’s like having your own tax-free cash stash for retirement!

Roth IRA vs. Traditional IRA: What’s the Difference?

The biggie that sets apart a Roth IRA from a traditional IRA is how they handle taxes. With Roth IRAs, you get to cash out tax-free when you retire. But with traditional IRAs, you snag a tax break when you put money in. So, if you’re keen on snagging an instant tax break, a traditional IRA could be up your alley. But if the thought of tax-free dough during retirement tickles your fancy, Roth IRAs might be more your speed. Dive into our Roth IRA vs. traditional IRA piece for a deeper dive into the contrasts.

How Does a Roth IRA Work?

A Roth IRA starts by taking money you’ve already paid taxes on from a qualifying source of earned income. This could be from a job, or it might come from rolling over funds from a Roth 401(k) plan, converting an existing traditional IRA or 401(k) plan, getting a spousal contribution, or some other transfer. (We’ll talk more about these options below.

Next up, you’ll pick a broker to open your Roth IRA and decide where you want to invest your cash. Over time, those investments could earn you a nice return.

Here’s where the magic of the Roth IRA comes in Although your investment growth might have been taxed if you withdrew the money elsewhere since you didn’t get a tax break when you funded the account, you’ll get to take your money out tax-free. Plus, unlike with a 401(k) or traditional IRA, you won’t have to start taking required minimum distributions (RMDs) once you hit a certain age.

And if you ever need the cash in your Roth IRA before retirement rolls around, you can pull out your contributions (but not any earnings) whenever you need to without facing extra taxes or penalties from the IRS.

What Can You Invest in With a Roth IRA?

If you’re up for taking a more hands-on approach with your Roth IRA investments, there are a bunch of options to consider. Here are a few:

  • Individual stocks
  • Individual bonds
  • ETFs (Exchange-Traded Funds)
  • Index funds
  • Mutual funds

Are Roth Iras Insured?

If your retirement account is with a bank that offers FDIC insurance, it’s covered, but it falls under a separate category from regular deposit accounts. What this boils down to for retirement accounts is that you still get up to $250,000 in insurance coverage, but that limit applies to all your traditional and Roth IRAs combined at that bank.

What’s a Spousal Roth IRA?

When a working spouse pitches in for their partner who earns little or nothing, a Roth IRA becomes what’s called a spousal Roth IRA. It’s a special deal that bends the usual rule stating only folks with income can contribute to their IRA.

Now, spousal IRAs come with their own set of strict rules. The couple needs to file taxes jointly, they’ve got to meet the income limit for Roth IRAs, and the account has to be in the name of the non-working spouse.

How to Open a Roth IRA in 6 Steps

1). Check if You’re Eligible.

Roth IRAs come with income limits, so while anyone can technically have one, whether you can contribute depends on how much you make each year. As your income climbs, the amount you’re allowed to contribute starts to shrink until it eventually hits zero.

For 2023, you can stash away up to $6,500 if your modified adjusted income falls below $138,000 for single filers or $218,000 for married folks filing jointly. In 2024, that limit bumps up to $7,000 if your MAGI is under $146,000 for singles or $230,000 for joint filers. And if you’re 50 or older, you can kick in an extra grand both years.

Once your income starts crossing those thresholds, your contribution limit starts to shrink until it vanishes entirely at $153,000 for single filers in 2023 ($161,000 in 2024), and $228,000 for married couples filing jointly in 2023 ($240,000 in 2024).

2. Decide What Type of Investor You Are.

If you’re the type who likes to handle things on your own, pick a brokerage.

You can hop over to an online broker and set up a Roth IRA, then take your pick of investments. It might be easier than you imagine — you can craft a well-rounded portfolio with just three or four mutual funds that cover various asset classes. When you’re checking out brokers, pay attention to their trade commissions and the fees on the funds they offer (they call these expense ratios).

If you’re more of a “handle it for me” type or prefer a hands-off approach, go for a robo-advisor.

If you’d prefer to have someone else choose your investment mix, you can set up your Roth IRA with a robo-advisor. These are online platforms that handle the task of building and managing a diversified portfolio on your behalf. While there’s a small fee involved, it’s usually much lower than what you’d pay for a human financial advisor.

3. Choose How Much You Want to Invest.

How much do you need to kickstart a Roth IRA? Typically, there’s no fee for getting one up and running, but there might be other expenses and conditions depending on who you go with and what investments you choose. Some brokers and robo-advisors — though not all — might ask for a minimum amount to get started, or they might charge fees when you buy or sell investments.

Take a moment to mull over your budget, how long you plan to invest, and your financial goals. It’s wise to only invest cash you won’t need in the next five years. This gives you room to weather any ups and downs in the market.

4. Select a Provider to Open Your Roth IRA.

The next step in opening a Roth IRA is finding the perfect home for your account.

If you’re a DIY investor, going with an online broker is a smart move. The best ones offer a wide range of low-cost investment options, like index mutual funds and exchange-traded funds (ETFs). They also provide handy retirement planning tools, solid customer support, and reasonable account minimums and fees. Plus, you get full control over how your retirement savings are invested.

But if you’re more of a hands-off investor, or you’d rather let someone else handle the portfolio management, a robo-advisor might be the way to go. These platforms typically have investment experts who design a variety of portfolios tailored to different types of investors. You can choose from portfolios with varying levels of risk, like “aggressive” for those keen on higher stock exposure or “conservative” for a steadier ride.

As an investor, all you need to do is set up your Roth IRA, link your bank account, and follow the provider’s instructions to build your portfolio. The robo-advisor takes care of buying the investments and managing your account over time.

Many robots also offer extra services to help you make the most of your savings, like goal-setting tools to keep your finances on track and strategies to trim your tax bill. (And yes, robo-advisors are typically registered investment advisors, following a similar setup to human financial advisors.)

5. Gather Your Paperwork.

Alright, so you’ve got the ins and outs of Roth IRAs down pat and you’ve even picked a provider. What’s next on the agenda? It’s time to round up any paperwork or documents you might need to get your Roth IRA account up and running.

The specific requirements can vary depending on the financial institution, but as a general guideline, here’s what you’ll likely need during the signup process:

  • Access to a working email and phone.
  • An ID, like your state driver’s license or passport, to confirm who you are, your address, and when you were born.
  • Your Social Security number or tax ID number.
  • Proof of employment, if it’s applicable to you.
  • The names, addresses, and birthdates of any beneficiaries you want to include on the account.
  • The names and addresses of any trusted contacts in case there’s a hiccup with your account’s security.
  • The routing and/or account numbers for the bank account you’ll be using to fund your Roth IRA.

6. Pick Your Investments.

The final step in mastering the art of opening a Roth IRA is figuring out how to invest the money in it. See, a Roth IRA is just the account shell; it doesn’t automatically grow your cash. To make that dough grow over time, you’ve gotta get it invested.

If you’re more of a hands-off type and you’ve gone with a robo-advisor to open your Roth IRA, they’ll take care of choosing a diverse investment mix for you.

But if you’re more hands-on, you can craft that diversification yourself by putting together a portfolio of index mutual funds and ETFs. To do that, you’ll need to decide how much of your stash you want to throw into riskier investments, like stock funds, and how much you want to keep safer in things like bond funds and cash. This blend is what they call your asset allocation.

Feeling a bit stuck? No worries, grab a model. Take a peek at the portfolios that robo-advisors use (they often show them off on their websites) and mimic them. Just remember to rebalance your investments as they drift away from your original allocation. You won’t have a robo-advisor to do it for you, after all.

What if You’re Not Eligible?

If your income puts you out of the running to contribute directly to a Roth IRA, don’t fret just yet. There might still be a way to snag those sweet tax perks.

Two routes to consider are a Roth IRA conversion and a backdoor Roth. With a Roth IRA conversion, you shift funds from a traditional IRA or a qualified employer-sponsored retirement plan (like a 401(k)) into a Roth IRA. If the money you’re moving got a tax break before, you’ll owe taxes on the conversion. But hey, you’ll still enjoy the perk of withdrawing any investment gains tax-free in retirement.

Now, a backdoor Roth is a variation of this conversion, specifically designed for high-earners who can’t contribute directly to a Roth IRA. They first make nondeductible contributions to a traditional IRA, then convert it to a Roth IRA. If it’s done right, a backdoor Roth usually won’t trigger taxes since no deduction was claimed for that initial contribution. But watch out for a couple of snags, like if you have an existing IRA balance or if there are any gains during the transfer.

What Are the Roth IRA Rules?

After you’ve set up your account, there are some important rules to keep in mind when it comes to withdrawing money:

Roth IRA withdrawal rules:

You’re free to take out your initial contributions whenever you like, without facing any penalties or taxes, regardless of how long your account has been open. That’s because the cash you’ve put in is money you’ve already paid income tax on.

When you make withdrawals from a Roth IRA, the IRS always assumes your original contributions come out first.

Folks aged at least 59 ½, who’ve had their accounts for at least five years, can withdraw funds, including earnings, without having to fork over federal taxes.

Roth IRA Withdrawal Penalty

Qualified withdrawals of investment earnings from the account are tax-free. But the catch is they have to be “qualified.” If you pull out earnings before hitting 59 ½, or if you don’t meet the criteria for a qualified withdrawal, the IRS might come knocking for a share of those returns, in the form of taxes and perhaps a penalty.

Some examples of qualified withdrawals before reaching age 59 ½ include buying your first home, covering qualified education expenses, paying health insurance premiums while you’re jobless, handling disability-related expenses, or welcoming a new addition to the family through birth or adoption. Just make sure you’ve got a good handle on all the ins and outs of these exceptions.

Frequently Asked Questions

What Are the Roth IRA Benefits?

The Roth IRA’s big appeal to investors lies in the potential tax perks. If you reckon you’ll be facing a higher tax bracket in retirement compared to now, a Roth IRA might trump a traditional IRA. Here’s why: You’ve already settled your tax dues on your contributions, so a boost in your tax bracket down the line won’t lead to a hefty tax hit when you’re ready to enjoy your nest egg.

And then there’s the rising inflation factor. Inflation chips away at the purchasing power of money over time. Letting your money grow tax-free can pack an extra punch, especially when inflation is on the upswing.

Should You Contribute to a 401(K) or a Roth IRA?

A 401(k) and a Roth IRA are both handy tools for stashing away cash for retirement and here’s the kicker: You don’t have to pick just one. If you qualify for a Roth IRA, you can stash money in that while also contributing to an employer-sponsored retirement plan like a 401(k). Of course, this means having enough dough to feed both pots, which isn’t always doable. If you’re in a pinch and have to pick just one, check out our breakdown of 401(k)s versus IRAs to help you decide.

What Is the Downside of a Roth IRA?

There are a few downsides to consider with a Roth IRA:

Five-year wait for tax-free earnings: You’ll need to wait five years from the tax year of your first Roth IRA contribution before you can withdraw earnings tax-free. This waiting period could be a downside if you’re nearing retirement. Pulling out contributions before meeting the five-year rule might mean paying income taxes plus a 10% penalty.

No tax deductions: Unlike with a traditional IRA, you won’t snag any tax deductions in the year you contribute to a Roth IRA. Tax deductions can be handy since they trim down your adjusted gross income and overall tax bill for the year. However, you might still qualify for the saver’s credit, which is a tax credit for making eligible contributions to an IRA. Just remember, this credit comes with income restrictions.

Income limits: Roth IRAs come with income limits, unlike traditional IRAs. If you earn more than the allowed amount, you might not be eligible for a Roth IRA.

How Much Money Do You Need to Start a Roth IRA?

Lots of discount brokers and robo-advisors these days have no minimum requirement to open a Roth IRA. But here’s the thing: the tax benefits of investing in an IRA only kick in when you actually start putting money into the account. According to the IRS, you can contribute up to $6,500 in 2023, or $7,500 if you’re 50 or older. But hey, you’re not obligated to max out your contributions. 

You can toss cash into your Roth IRA whenever and however much fits your budget. Many brokers and robos even let you set up automatic deposits, making it a breeze to transfer money from your bank straight into your Roth account.

Can You Lose Money in a Roth IRA?

Absolutely! You’ve got options when it comes to where you stash your IRA cash, and let’s be real, some of those options might see a dip in value, especially in the short run. That’s why it’s crucial to know your risk tolerance when you’re picking investments. Dive deeper into how to invest your IRA and make informed decisions.

How Much Will a Roth IRA Earn?

Depending on how you’ve invested your money, you could see an average annual return of around 7% to 10% with your Roth IRA. But keep in mind, this can vary depending on how the market performs each year, so there’s a chance you might earn less at times too. It’s a good idea to regularly review your goals, how much time you have until retirement, and the investments you’ve chosen. This way, you can make informed decisions about how to manage your Roth IRA returns.

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