How to Start a Roth IRA in 2020: Roth IRA Guide to Save for Retirement (2024)

The Roth IRA started in 1997, when it was passed into United States law as part of the Tax Payer Relief Act. The Roth IRA was championed by American veteran and long time United States Senator, William Victor Roth, for whom the account is named after.

If you meet the qualifications and expect to have a higher taxable income later in life, a Roth IRA may be an ideal retirement savings vehicle for you.

Any age is a great age to start a Roth IRA, so long as you have earned income. Roth IRAs are especially powerful for young people (as long as they have earned income), giving their investments more time to compound and grow.

Roth IRAs are a terrific complement to 401Ks and other retirement plans. We’ll cover those in the next chapter.

There are some Roth IRA limits. Roth IRA annual contributions are capped (currently $6,000 a year for those under 50), and contributions over this limit result in a 6% penalty on your taxes.

Also, you aren’t allowed to contribute to a Roth IRA if your income is above a certain limit. There’s a workaround this we’ll cover later.

Ifyour modified adjusted gross income (MAGI) andadjusted gross income (AGI)are not the same, your MAGI, which is used when checking Roth IRA contribution limits, may be a larger number than your AGI. This is because your modified adjusted gross income (MAGI) does not account for certain deductions, like student loan interest, qualified tuition expenses, and traditional IRA contributions.

If this sounds confusing, don’t worry! Your tax software will automatically calculate MAGI for you during tax time. And this is only an issue for people with large incomes.

If you’re a high income earner and concerned that you may be close to going over the Roth IRA income limits, you should consult a tax professional before contributing to a Roth IRA.

When deciding between a traditional IRA or Roth IRA, ask yourself: will my tax rate be greater now or in retirement? Do I want a tax break now, or later in retirement?

Assuming your tax bracket is the same now and in retirement, traditional IRAs and Roth IRAs are equally tax-efficient.A traditional IRA may be the better option if you expect to have a lower tax rate in retirement and don’t need the added flexibility of a Roth IRA.

Also consider future tax rates. If you expect taxes to rise in the future, paying taxes now with a Roth IRA may be more appealing.

Quick Tip! How to diversify your retirement savings with different accounts.

Assets in both tax-deferred accounts (liketraditional IRAs)and tax-exempt accounts (likeRoth IRAs)serve as a form of tax diversification. Having differently tax-advantaged accounts in retirement gives you added flexibility when taking distributions to better control your annual tax bill.

Did you know? You can open both a traditional IRA and Roth IRA, as long as total contributions to both accounts are below the annual contribution limit ($6,000 total for both accounts for those under 50). However, many people already have access to tax-deferred investments through a workplace 401k.

Yes, you can convert a traditional IRA to a Roth IRA. This process is sometimes called a “backdoor Roth IRA” because it allows high income earners to contribute to a Roth IRA.

Since the Roth IRA is a tax-exempt account (you don’t pay taxes on qualified distributions), you will be taxed on the funds you transfer from the traditional IRA into your Roth IRA. If transferred correctly, there will not be an early distribution penalty during the conversion.

A 401(k) is an employee sponsored tax-deferred retirement account. You contribute pre-tax income to a 401(k). This is money you’ve earned but have not yet paid taxes on.

Thus, your 401(k) contributions lower your overall yearly taxable income, so you’ll pay less in taxes for each year that you contribute. However, you’ll still pay regular income taxes later on the money you withdraw from your 401(k) in retirement.

A 401(k) typically benefits from an employer matching program to encourage saving for retirement. The match is usually a percentage of your contribution, up to a certain percentage of your salary.

This match is sometimes called “free money” because it is a contribution paid out entirely by your employer. Therefore, it’s usually advised to first contribute enough of your salary to a 401(k) to get the full employer match before saving in other retirement accounts, like a Roth IRA.

If your company offers a 401(k) matching program, it’s usually advised to first contribute enough to get your employer’s full match before investing in a Roth IRA. If possible, it’s usually a good idea to contribute to both a 401(k) and a Roth IRA.

A 401(k) is a tax-deferred account (like a traditional IRA) and a Roth IRA is a tax-exempt account. Investing in both kinds of retirement accounts gives you added flexibility when managing your taxes in retirement.

Depending on how much money you’ll need to live in retirement, a 401(k) may allow you to save enough for retirement. However, a Roth IRA is still a great complement to your 401(k). After contributing enough to your 401(k) to qualify for your company’s full match, it may be a good idea to contribute to a Roth IRA.

In addition to saving more money for retirement, a Roth IRA’s tax-exempt status offers increased tax diversification that may be helpful in your golden years.

The 401(k) comes in another flavor, the Roth 401(k). Like the 401(k), a Roth 401(k) is an employer-sponsored retirement plan and often benefits from an employer matching program.

The Roth 401(k) is like a Roth IRA in that employee contributions to a Roth 401(k) are made with after-tax dollars. However, employer contributions do not get the same Roth tax treatment as employee contributions.

Matching funds are deposited in a traditional 401(k) account, meaning you will owe taxes on the employer contributions and earnings when the money is withdrawn in retirement. This can make early withdrawals more complicated than with a Roth IRA. Additionally, unlike a Roth IRA, a Roth 401(k) is still subject to required minimum distributions.

To contribute to a SIMPLE IRA, employees must have earned at least $5,000 in compensation during any two preceding calendar years and expect to earn at least that much during the current year. Contributions are made with pre-tax dollars and employer matching funds are immediately vested (they immediately belong to the employee with no wait time).

The Simplified Employee Pension (SEP) IRA is a tax-deferred retirement plan that works best for self-employed people or small business owners with very few employees.

A SEP IRA is similar to a traditional IRA, but has much higher contribution limits. In 2020, SEP IRA contribution limits are either 25% of total compensation or $57,000, whichever is less. Even better, owning a SEP IRA will not affect your ability to save in a Roth IRA or traditional IRA. These benefits make the SEP IRA a powerful tool for self-employed people to save for retirement.

A Self-Directed IRA (SDIRA) is a type of IRA that can hold alternative investments, like real estate, cryptocurrencies, gold and other precious metals, and even private companies. A Self-Directed IRA can be set up as a traditional or Roth Self-Directed IRA.

While all IRAs require a custodian (like a bank or investment company) that holds your investments, a Self-Directed IRA uses a custodian that specializes in offering non-traditional investments.

In addition to the standard custodial Self-Directed IRA, you can also use what is called a “checkbook IRA”.

A checkbook IRA, also known as a Checkbook Control Self-Directed IRA, is an IRA in which the custodian establishes a legal entity, usually a limited liability company (LLC), that is held within the IRA and managed by the account holder. The account holder is then freely able to invest in non-traditional assets, like real estate or cryptocurrency, as long as they do not violate the prohibited transaction rules.

Although all investments have inherent risk, the use of a Self-Directed IRA to invest in alternative assets may carry even higher risks. The U.S. Securities and Exchange Commission has even outlined some of these risks, including the possible risk of fraud.

Additionally, the use of a Self-Directed IRA, either custodian controlled or with checkbook control, can come with many different kinds of fees not typically associated with standard traditional IRAs and Roth IRAs.

Am I ready to save for retirement?

Saving for retirement should be just a part of your overall financial plan. Before revving up retirement savings, I suggest paying off high interest debt and saving an emergency fund.

So how does a Roth IRA fit in with your other financial goals? Here’s a step-by-step list of how to save and invest your money, in order of importance.

This may seem obvious, but creating a budget is essential to long term financial success. Live below your means and cut non-essential expenses. Life is about making decisions, so think about what’s most important to you and aggressive cut spending in other, less important, areas.

There are three spending categories that can typically zap a lot of your income and hinder savings: transportation, food, and housing. Save money here and reap the rewards!

Cutting back? Here are a few of my favorite money saving hacks:

• Drive a reliable, affordable used car. I drive a 2007 Toyota Prius that gets 45 miles per gallon and has very low maintenance costs. Sure, I could drive a nicer, newer car. But I’d rather spend that money on other things (like a nice dinner date… or investing in my Roth IRA and workplace 401k!).
• Cook at home, dine out less often. I’ll admit, dining out and takeout or delivery still “eats” more of my budget than I’d prefer. Cooking at home is great for two big reasons: it’s a lot cheaper and it’s usually healthier. Last year I invested in an Instant Pot and I have loved learning new recipes that are quick and easy to make. It’s not quite as tasty as eating at my favorite local Indian restaurant, but it’s much more cost-effective.
• Downsize your home or get roommates. Housing, through rent or mortgage payments, is often our biggest expense. Cutting back here can instantly put a hefty chunk of money back in your pocket each month. To save, consider downsizing to a smaller home, moving to an area with a lower cost of living, or living with roommates. And while real estate can be a great investment, there are still real benefits to renting. Weigh your options and consider what makes the most sense with your personal and financial goals.

An emergency fund is not an investment- it’s money that’s easy accessible in case of an unexpected, emergency expense.

For example, if your car needs a big repair or you have an unexpected medical bill, your emergency fund has you covered.

Should you have an emergency fund before saving for retirement? It’s important to build an emergency fund before investing, because an emergency fund protects your investments.If an emergency arises, you can withdraw from your emergency fund. Thus, you’re not tapping your Roth IRA or other investments, and they can continue growing.

For most people, saving 3 to 6 months of living expenses in their emergency fund is a good goal. Remember, this money needs to be accessible in case of emergency and should not be invested. I recommend keeping this money in a high-yield savings account with no minimums or fees. In my experience, Capital One typically offers some of the best online savings accounts with relatively high returns.

While some debt, like a mortgage and some educational loans, can be tools for helping you grow your wealth over time, having high-interest debt (like credit card debt, which can have 15 – 25%+ APRs) is the antithesis of wealth building.

Should you pay off debt before saving for retirement? Yes, pay off these high-interest debts, and pay them off aggressively. High-interest debt should be paid off before investing, because virtually no investment can make you more money than what you’re paying in interest on this debt. While paying off high-interest debt, a smaller emergency fund (one month’s worth of living expenses) is usually appropriate.

Should I take my retirement match at work? If your employer offers to match a percentage of your contributions to a retirement investment plan (typically a 401k), make sure your contributions are at least enough to get these matching funds.

This match is sometimes called “free money” because it is a risk-free, guaranteed return on your investment. Pretty cool, right?

When planning your contributions, be sure to review your plan’s vesting schedule. Vesting refers to the ownership of your retirement funds, particularly the employer matching funds.

Companies typically create a vesting schedule, a schedule outlining what percentage of employer contributions you actually own for each year you are employed. For example, some companies don’t allow employees to be fully vested, meaning 100% ownership of employer contributions, until they’ve worked with a company for a set amount of years.

Noticing a theme here? Getting out of debt is really important to building financial security!

If the interest rate on your debt is moderate (over 5%, excluding mortgage), consider also paying this off before investing elsewhere. Think of paying off this debt as a guaranteed return of the interest rate

Once you’ve met your yearly retirement savings goals, consider tax-advantaged savings plans, including a Health Savings Account (HSA) or 529 Plan.

• Health Savings Accounts (HSAs) are tax-advantaged savings accounts that allow you to save for future health care expenses with pre-tax money. To qualify, you’ll need a high deductible health insurance policy. In 2022, that means a minimum deductible of $1,400 on an individual policy or $2,800 for a family policy.
• A 529 Plan is a state-sponsored, tax-free savings plan for a child’s eligible college expenses, like tuition, books, and fees. Additionally, these plans can also be used to save for private K-12 school education.

Other reasons to save during this step include: saving for a down payment for a house, saving for a car, or vacation funds. This money is typically saved in a savings account, but can also be invested in a taxable brokerage account for longer term goals of five years or more.

Many financial professionals recommend socking away at least 15% of your pre-tax income for retirement.

This is a good starting point, especially for younger people without a solid idea of how much money they’ll really need for retirement. For those who are closer to retirement, your retirement savings rate becomes a lot more personalized to your needs.

Many people don’t think much about retirement until their 40s or 50s, and realize their current retirement savings rate won’t be enough to propel them into the retirement lifestyle they want. Thus, older workers tend to start funneling more of their income into retirement savings.

By saving more at a younger age, your money has more time to grow through the power of compounding.

To calculate your estimated retirement savings goal, multiply your estimated required annual retirement income by 25. For example, say you anticipate needing $40,000 per year during retirement. Quick math: $40,000 x 25 = $1,000,000.

So assuming a 30 year retirement, you’ll need at least a million dollars in retirement. This calculation is based on the 4% rule.

The 4% Rule is a retirement investment withdrawal guideline developed by financial advisor William Bengen.

According to Bengen’s rule, if you withdraw four percent of your total investments during your first year of retirement, and adjust the dollar amount you withdraw to account for inflation for every following year, you will very likely have enough money for a 30-year retirement and not outlive your investments.

While not perfect, this rule is a good starting place for retirement planning. This assumes a retirement portfolio of approximately half stocks and half bonds. We’ll cover the best investments for your Roth IRA and retirement accounts in a later chapter.

How does compounding work? Saving for retirement is a financial challenge, but compounding growth helps make it possible!

Say you make $50,000 and save 15% of your pre-tax salary for 30 years. (50,000 x 0.15) x 30 = $225,000.

What? That’s nowhere near the amount most people will need to fund a 30 year retirement.

Even those who don’t make a high salary can effectively save for retirement. By putting away 15% of each paycheck and saving early, many people should be able to save for a comfortable retirement nest egg.

So how does this add up to become enough for retirement? The answer is compounding growth. Compounding growth is like a rocket ship, taking your retirement savings to new heights!

As your investments grow through capital gains and dividend payouts, that new, higher total amount earns even more money. This is compounding.

Investments in a Roth IRA, and other retirement accounts, can build massive wealth over time through compounding.Here’s an example of $6,000 invested annually at a 7% rate of return, compounded annually:

A Roth IRA can hold most kinds of financial assets and investments, including cash. However, holding cash in your Roth IRA is typically not recommended because cash tends to lose value every year due to inflation.

So while you can just deposit cash into your account, it is recommended that once you’ve deposited cash into your Roth IRA account, you use it to purchase and hold investments (such as index funds, stocks, bonds, mutual funds) that should grow in value over time.

Remember, think of your Roth IRA account as an empty box for you to fill with investments.

Index funds and ETFs (exchange-traded funds) are popular choices for Roth IRA investments due to their low costs, simple diversification, and record of reliable growth that mirrors large financial indexes.

Index funds and ETFs are bundles of different investments, like stocks and bonds, packaged together in a single investment that you can buy. The main difference: index funds are a type of mutual fund, and sold by brokers, usually requiring a minimum investment. ETFs can be bought and sold like shares of a stock.

Index funds and ETFs are lauded by some prominent financial experts, like Warren Buffet. Historically, Index funds and ETFs have performed just as well, or better, than many actively-managed funds.

Index funds and ETFs are passively-managed, meaning they often have very low fees. A passively-managed fund means the fund’s investments are automatically selected to follow a specific index (for example, the S&P 500), not hand-picked by a portfolio manager.

Quick Tip! Here’s Why and How to Check Investment Fees.

Before investing, always check the fees. Primarily, you’ll want to check the expense ratio, the percentage of the fund that is used for management fees. Essentially, the expense ratio is a fee charged by the company offering the fund.

Lower expense ratios are better because more of your money is actually invested in financial assets, not going towards fees. While these fees are often small, usually less than 1% of the overall investment, they can add up over time and result in lower long-term gains.

Fees can sometimes go unnoticed by investors because they are part of the overall investment, not paid separately. Before investing, search for the fund online and find an overview which details all fees, including the expense ratio.

Diversification is something to keep in mind as you select Roth IRA investments. A diverse portfolio of investments will help your Roth IRA weather the ups-and-downs of the markets, and avoid having too much of a stake in any one area or type of investment.

One simple, affordable way to diversify your retirement accounts are with Target Retirement Date Funds.

New investors who want to save for retirement in a Roth IRA but don’t know, or care to learn, much about investing should consider Target Date funds.

Target Date funds are easy to invest in, have low fees, and require a very minimal understanding of investments. Instead of choosing multiple investments, investors can choose one Target Retirement Date fund for a simple, diversified portfolio.

Specifically, Vanguard Target Retirement Funds are quite popular for their low fees (currently only a 0.15% expense ratio) and low minimum investments. Like we mentioned above, an expense ratio is an annual fee expressed as a percentage of your investment. Basically, the lower the expense ratio, the less of your money you’ll lose to fees.

Investors choose a Target Date fund that matches their prospective retirement date. For example, Vanguard Target Retirement 2055 Fund (VFFVX) is designed for investors who expect to retire around the year 2055.

By investing in Target Date funds, portfolio rebalancing is done for you automatically within the fund, and you never have to worry about asset allocation. Over time, as the retirement date nears, the fund’s asset allocation changes, favoring more conservative assets (i.e. bonds) over more aggressive assets (i.e. stocks).

These funds are incredibly easy to use- just invest in the same fund every year and you’re done!

Investors who like the diversification offered by Target Date funds and want the lowest fees, but don’t mind choosing their own funds and balancing their own portfolios might consider John Bogle’s three-fund portfolio.

Developed by Vanguard’s John C. Bogle, the three-fund portfolio is a simple, diversified portfolio typically composed of a domestic stock total market index fund, an international stock total market index fund, and a bond total market index fund.

For example, using Vanguard funds for the three-fund portfolio would include:

• Vanguard Total Stock Market Index Fund (VTSAX)
• Vanguard Total International Stock Index Fund (VTIAX)
• Vanguard Total Bond Market Fund (VBTLX)

While many popular Target Date funds offer low expense ratios, the index funds in this three-fund portfolio are typically even more cost effective. These index funds are offered by many different brokers and often offer expense ratios of less than 0.05%.

By using broad-based index funds composed of stocks and bonds, the three-fund portfolio offers tremendous diversification with very low fees.

However, this portfolio requires a little more effort than Target Date funds, requiring investors to choose their own asset allocation (how much is invested in each of the three funds).

Quick Tip! How toChoose the Right Asset Allocation for Retirement.

Typically, stocks are riskier investments, but offer the opportunity for greater returns. While bonds are more conservative investments, offering security but lower returns.

Depending on their financial goals, age, and risk tolerance, investors can choose their asset allocation to be more aggressive (more of the portfolio invested in stocks) or more conservative (more of the portfolio invested in bonds).

While risk tolerances vary from person-to-person, younger investors with a longer time horizon can usually benefit from more aggressive portfolios (more stocks), while older investors approaching retirement may favor the security of more conservative portfolios (more bonds).

For example, a 30-year-old investor may favor a more aggressive three-fund portfolio with this asset allocation:

• 80/20 Portfolio:64% U.S. stocks, 16% International stocks, 20% bonds

While a 65-year-old investor nearing retirement may favor a more conservative three-fund portfolio with this asset allocation:

• 20/80 Portfolio: 14% U.S. stocks, 6% International stocks, 80% bonds

Over time, investors may want to rebalance their portfolios in favor of more conservative. Unlike Target Date funds, investments in the three-fund portfolio will need to be rebalanced manually.

The easiest way to rebalance your portfolio is to simply buy more of an asset over time. For example, in a Roth IRA, as an investor ages, they might choose to purchase more bonds (through a bond total market index fund) as part of their annual contribution.

However, rebalancing this way can be slow. When faster rebalancing is needed, you can sell off investments you want less of and buy investments you want more of to reach the new, desired allocation.

Dollar-cost averaging (DCA) is an investment strategy where equal amounts are invested at regular intervals of time in an effort to mitigate the highs and lows of the market and pay a lower average price for an overall investment.

Basically, focus on investing consistently in your retirement accounts instead of attempting to predict when stock prices will be low.

You’re saving money for retirement. Go, you! Now, we’ll find the right home for your shiny, new Roth IRA investments.

Opening a new account can be scary and intimidating for first time investors. Never fear! Starting a new Roth IRA is quite straightforward, and usually can be quickly completed online.

To open a Roth IRA, you’ll need your:

• Social Security number
• Bank checking or saving account numbers and routing numbers (to move funds into the Roth IRA)
• Employer’s name and address

Quick Tip! How to Keep Your Private Info Safe.

Because you’re dealing with your sensitive personal information, I recommend opening your account at home on your private home computer and internet connection.

Do not use a public wifi connection while opening or accessing your financial accounts, as these connections could be less secure, leaving your sensitive personal and financial information vulnerable.

There is no maximum amount of Roth IRAs accounts an individual can have, but the total of all contributions across all accounts cannot surpass the Roth IRA contribution limit.

What is the best place to open a Roth IRA in 2022? Here are some of my favorite places to open a Roth IRA:

Starting a Roth IRA is straightforward and can be completed online in less than 15 minutes.

In this example, I’ll show you the step-by-step instructions for opening a Roth IRA with Vanguard.

Step 1
Go to Vanguard’s website and select “Personal Investors”. On this page, choose “Open an account online”. This will open a page outlining the new account process.

Step 4
After entering your banking account information to fund your new account, you’ll be asked how much you want to contribute right now.

Tip: If you’re still eligible to contribute to your Roth IRA for last year, wait to max out that year’s contribution before contributing for the current year.

Finally, you’ll submit your application. I suggest signing up for electronic communications to prevent paper waste and unnecessary fees.

Congratulations on opening your very own Roth IRA!

To invest in bitcoin or cryptocurrency in an IRA, you’ll need to open a Self-Directed IRA (SDIRA) with a custodian that either specializes in cryptocurrency or offers checkbook control.

Remember, bitcoin and cryptocurrency are considered “high risk” investments. Additionally, investing in bitcoin or cryptocurrency with a custodian is a more complex process, and often results in higher fees than a standard Roth IRA account.

It depends on your personal financial situation and risk tolerance. Like we mentioned earlier, bitcoin, and other cryptocurrencies, are typically used as speculative investments and carry a high level of risk.Investing in bitcoin in a Roth IRA requires the use of a Self-Directed IRA, often resulting in additional custodial fees.

As always, I recommend you should consult a financial professional before making any serious investment, including bitcoin. Before opening a Self-Directed IRA or investing in cryptocurrency, consider consulting with a financial professional. Before choosing a custodian for your Self-Directed IRA, be sure to research their reputation and all associated fees.

Although all investments have inherent risk, the use of a Self-Directed IRA to invest in alternative assets, like cryptocurrency, may carry even higher risks. The U.S. Securities and Exchange Commission has even outlined some risks of using a Self-Directed IRA, including the possible risk of fraud.

One of the major benefits of a Roth IRA is flexibility. You can pull contributions out of your Roth IRA account, penalty-free at any time.

Additionally, you may withdraw up to $10,000 of investment earnings from a Roth IRA with no tax or penalty if you opened and contributed to the account at least five years earlier and the withdrawal is for purchasing your very first home.

But remember, taking money out of your Roth IRA early means you’ll be losing out on years of beautiful tax-free, compounding growth.

It depends on the interest rate of your student loans. If your student loan has an interest rate of 5% or lower and you’ve already established an emergency fund (three to six months of expenses), taken advantage of employer-sponsored matching funds (like a 401k), and paid off other moderate to high interest debt, you may want to prioritize retirement investing through a Roth IRA over paying off student loans.

Student loans, or any debt with moderate (over 5%, excluding mortgage) to high (over 10%, like most credit card debt), may be a priority to pay off before making Roth IRA investments.

The flexibility offered by a Roth IRA through the ability to withdraw contributions (not the earnings/growth of your investments) penalty-free at any time allows the Roth IRA to serve as an emergency fund option if absolutely necessary.

To avoid a penalty, you’ll need to refrain from withdrawing any earnings from your Roth IRA until age 59 ½ and have opened and contributed to your account at least five years prior. To avoid withdrawing earnings, reference past contribution totals and do not withdraw a total amount exceeding your contributions.

Yes. Because a Roth IRA grows tax-free and has no required minimum distributions over the life of the primary account holder, these accounts work well for inheritance. Investors who want to leave their accounts to an heir must name them as a beneficiary. Beneficiaries are required to take required minimum distributions from the inherited Roth IRA account.

Yes, but kids must contribute their own earned income. There are no age limits for opening a Roth IRA. For minors (anyone under age 18), a parent or guardian can open a custodial Roth IRA for their child. However, parents cannot contribute to a Roth IRA on behalf of their children. The kids must have earned income (ie taxable income and wages) of their own to contribute to a Roth IRA. Once the child turns 18 years old, the custodial Roth IRA will become a standard Roth IRA.

Yes, you can open and fund a spousal IRA or spousal Roth IRA. If your income is below the capped amount, you may contribute to your husband or wife’s Roth IRA, up to the maximum allowed, from your own earned income. The Roth IRA married couple contribution limits are calculated the same as individual limits: $6,000 for individuals under 50, and a $7,000 for those 50 and older. However, total married Roth IRA contributions for both spouses can’t exceed your total earned income