A Roth IRA is one of the coolest parts of the tax code. Basically, you put aside money for retirement that you’ve already paid taxes on. What’s so great about that? Well, you don’t have to pay any taxes on it later, when you pull it out in retirement – and that includes any investment gains you’ve earned along the way. While traditional IRAs give you a current-year tax break when you put the money away, those funds (including investment gains) do get taxed when you take them out later in life.
When would you want to use a Roth IRA instead? If your tax bracket is lower now than it will be when you retire. This makes it an ideal choice for younger workers who are still at the low end of the tax bracket to start saving for retirement. But truthfully, almost anyone could benefit from having at least a portion of their retirement savings in a Roth IRA.
Okay, not quite everybody. Because of their enormous tax benefits, Roth IRAs are heavily regulated. Here are some details to know before you jump and open a Roth IRA — including whether you qualify to open one at all:
- IRA contribution limits: First, there are limits on how much you can put into an IRA every year. In 2016, you can contribute no more than $5,500 per year to all of your IRA accounts combined (that includes both Roth IRAs and traditional IRAs). Once you hit age 50, you’re allowed to contribute an extra $1,000 per year, for a total of $6,500.
- Roth IRA income limits: Roth IRAs also have income limits — meaning people who earn above a certain threshold can’t take full advantage of them (at least not that tax year). In 2016, single taxpayers earning $134,000 or more can’t contribute to a Roth IRA, while the cutoff is $194,000 for married taxpayers filing jointly. There are ways around that — namely something called a “backdoor Roth IRA” — but if you’re earning well into the six figures, you may be do better to take advantage of a current-year tax break using a traditional IRA anyway.
- Employer 401(k) match comes first: Finally, before going any further, we should point out that you should not be looking at alternative investment and retirement strategies until you have maxed out any matching 401(k) contributions from your employer. That’s basically free money, so there’s no sense looking elsewhere until you’re squeezing every dollar out of your employer’s 401(k) matching program.
Now that we have that dark rain cloud out of the way, here’s the skinny on how to open a Roth IRA.
Where and How to Open a Roth IRA
Once you’re ready to start a Roth IRA, you first need to find a good IRA provider. From popular online discount brokers like E*Trade and Scottrade, to mutual fund powerhouses like Vanguard and Fidelity, there are plenty of solid options to choose from — you can start by checking out our favorite IRA providers here.
You should be able to open a Roth IRA without fees. If you can’t, look for low fees — where “low” means less than 1%. Don’t be mistaken: Fees can eat up tens of thousands of dollars or more over the life of your investment, so get those fees as low as possible (or nonexistent where you can). You also want to open your Roth IRA somewhere that offers a wide array of no-load and no-transaction-fee mutual funds and ETFs, meaning you can invest in them repeatedly without paying a commission.
Those who are new to investing may want a strong customer service component. If you’re unfamiliar with investing and uncomfortable researching financial strategies on your own, you might need some kind of advice to get you started. That might mean a lot of hand holding and a dedicated customer service representative, or just some good online resources to guide you. Either way, if you’ve never done this before, find a place that’s going to walk you through it and answer any of your questions.
Finally, especially for low- and middle-income earners or those just starting out, you want low account and funding minimums — meaning you can open an account and invest in a mutual fund with, say, $500, not $5,000. Otherwise you won’t even be able to get your foot in the door. Note that both of these minimums matter: Sure, the firm might have no minimum account balance, but if all the available mutual funds have a minimum investment of $10,000, you might be out of luck.
Once you’ve picked a provider, opening an account is as easy as going to their website, entering your personal information, and linking up a funding source, such as your checking account. You might be rolling over an existing 401(k) or other retirement fund into this account as well, which is also a lot easier in the age of the Internet than it used to be. The website or a customer service rep should walk you through this process, but pay attention to any tax implications when rolling over a tax-advantaged account.
Automating and Managing Your Roth IRA
You can often get very low fees from robo-advisors (such as Wealthfront or Betterment), who basically let computers invest your money for you based on your age, risk tolerance, and long-term goals. The computers do a pretty good job of investing your money efficiently, and the fees are lower, but there’s often very little in the way of investor education.
Target-date funds, meanwhile, are sort of the old-school version of the robo-advisor. These mutual funds invest your money in a single, highly diversified fund that automatically adjusts its holdings to get more conservative as the “target date” of your future retirement draws closer.
Going forward, the main thing to remember is to make sure you’re making regular contributions to the account — after all, your savings rate is the most important factor when it comes to your investing success. Your provider can help you do that by setting up automatic withdrawals from your checking or savings account. Remember that there are limits on how much you can contribute to a Roth IRA each year, so be cognizant of that — though most IRA accounts will cut you off when you’ve hit your annual limit.
Keep in mind that a Roth IRA is just an account — you still need to invest the money. That’s where picking the right provider will come in — every IRA account will offer different investing options and resources. Brokers such as Scottrade will allow you to invest in just about anything, including stocks, within your Roth IRA, while other companies may limit you to index funds or a handful of ETFs.
A Roth IRA might sound complicated, but once you’ve got one up and running you can basically set it and forget it. Put in a couple hours of legwork today, and it will pay dividends for the rest of your life. Better yet, you’ll be able to withdraw those funds — including potentially decades of investment gains if you start early — totally tax-free once you hit retirement.