Everything you need to know about opening up a ROTH IRA and why NOW is the best time to start.
This is a 100 year view of the Dow Jones Industrial Average. As you can see from the chart (below), depending on your point of view, from 1928 to now, we’ve had about 3–4 periods of steep decline in the stock market. The other thing that you’ll notice is that after each decline, there has always been a recovery period — and in the long term, the stock market has always gone higher, than it was before.
Now with this pandemic, we are currently in a decline period in the stock market, but if you believe in the past track record of the market, then this point gives you a great opportunity to start an investment position and watch it grow as we approach the next few years of recovery. And one of the best ways to invest in the market is to open up a ROTH IRA.
So in this article, I’ll talk about all of the details of a ROTH IRA and explain why it can be one of the smartest financial vehicles to utilize in your investment and retirement strategy.
Welcome to Daniel’s Brew — where I cover personal finance, investing, and career development topics.
Intro to IRAs
So let’s start off by doing a quick intro about IRAs in General.
IRA stands for Individual Retirement Account and they are financial investment vehicles that are typically designed to hold your money until retirement age and give you some tax benefits (either upfront or deferred) for utilizing them.
The 5 most common IRAs are:
1) Traditional IRAs
2) ROTH IRAs
3) Non-deductible IRAs
4) SEP IRAs
5) SIMPLE IRAs
The last 2 are related to small businesses and self-employed entities, while the first 3 are more commonly used by most everybody else.
But today, we’ll be talking primarily about the ROTH IRA.
1) How to Set Up a ROTH IRA
A Roth IRA is a retirement account that you can set up at most retail financial institutions — from major banks, like Bank of America & Chase, to financial service firms like Vanguard or Fidelity. To set one up, you can easily log on to any of their websites and follow the instructions, or simply walk into a physical branch location and talk to a financial advisor.
All you need to set one up is just your personal information and an account at one of these institutions. And there are only 2 requirements you need to MEET in order to be eligible to open one up — a source of earned income (like a wage or salary from a job) and you have to make less than the IRS income limit for this type of account. This income limit changes every year, but as of 2020, you have to make less than $139k for individuals and less than $206k for those married and filing taxes jointly.
Now, once you’ve set up the account, you can have it funded with your initial deposit, and set up recurring deposits — and you can choose to use your funds to purchase any equities that are available for you through that financial institution.
And depending on which firm you choose, your choices will differ. For example, providers like Fidelity have their own proprietary mutual funds that they’ve developed, that you won’t be able to find at, say Vanguard, and vice versa. (So if you’ve already done some research to pick the equity you want to invest in — just make sure to check, to see if it’s available wherever you open up your ROTH IRA.)
2) ROTH IRA Taxes
Secondly, let’s talk about taxes.
When you enroll in a 401k or a Traditional IRA, those accounts are what we call Tax-deferred, meaning your contributionsare not taxed upfront and you delay paying the taxes until you withdraw your money, after retirement age.
A ROTH IRA is different in the fact that they are Tax free accounts — which means, you first contribute after-tax money and the amount that you put into the ROTH grows tax free and when you take distributions from the account after retirement age, your withdrawals are also not taxed. That means once you’ve put your after-tax money in your ROTH IRA account, you never pay taxes on that money or it’s growth, ever again. This makes it a very attractive investment vehicle for most people — especially those that start early and plan to let this account grow for a very long time.
3) ROTH IRA Contribution Limits
The next thing to note about Roth IRAs is that they fall under the total contribution limit for all IRAs within the given year.
You see, most retirement/investment accounts have a yearly contribution limit — for example, in 2020, you can contribute up to $19,500 to your 401k, up to $3,550 to your HSA account, and up to $6,000 for all of your IRAs combined.
So what that means is — in aggregate (for the calendar year), you cannot have more than $6,000 contributed to all of your IRA accounts. So if you have a traditional IRA already and you are contributing to that — you’ll want to make sure that you balance that out with whatever you want to put into your ROTH— so that the combined total does not exceed $6,000 annually.
Now these numbers are for individual tax filers — if you are married filing jointly or are over the age of 50, your numbers will be different. I recommend visiting the IRS webpage on ROTH IRAs to learn the exact limit number for your situation.
4) ROTH IRA Distribution Rules
Now on the topic of distributions, ROTH IRAs are unique in that for the contributions you’ve made (the amount of money you’ve already paid taxes on and directly deposited) — you can actually take out that money any time you want. It’s your money that you already paid taxes on — so the IRS has no problem if you want to withdraw that, at any point.
But what about the growth that your contributions have made in the account? Well for that, the IRS has just 2 critical rules you have to follow to take full advantage of tax-free distributions of the growth earnings.
- First, you have to be over the age of 59 1/2 before you start your withdrawals of the earnings.
- Secondly, you have to have held the ROTH IRA for at least 5 years.
Now if you don’t meet these 2 criteria, then the earnings distributions you take will have the added cost of tax and a 10% penalty — unless you decide to use these funds for a 1st time home buy or for educational purposes. For those two specific costs, the IRS will allow you to withdraw from your ROTH IRA early — but it comes with a few stipulations, of course. Again, for those details, you’ll want to check out the IRS site directly.
One last thing about ROTH IRA distributions — unlike traditional IRAs or ROTH 401ks, ROTH IRAs do not have a RMD — Required Minimum Distribution. That means you do not have a required amount that you need to withdraw each year from the account after you hit retirement age. So you can keep that money in the ROTH IRA for as long as you’d like or withdraw as soon as and as much as you want, as long as you’ve satisfied the 2 distribution rules we just discussed.
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So that’s ROTH IRAs in a nutshell — next to HSA accounts, I believe that ROTH IRAs are the best option for putting away your money until retirement. The fact that it grows tax free and distributions are tax free, after you meet the two qualifying rules, makes it an incredibly awesome growth vehicle for your investments.
ROTH IRAs, can be an immensely critical tool in your retirement portfolio — so make sure you check it out if you haven’t already. And given that we’re in a decline period now — this might be a good time to start a ROTH, in anticipation of approaching an upcoming recovery period. But that’s just my opinion — you’ll have to make that decision for yourself.
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The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.
