I opened my first Roth IRA on April 6, 2005. At the time, I was still a college student and barely had earned income. I deposited approximately $2,700 into that account and selected stocks based on a careful analysis of the companies’ financial reports (I no longer select stocks in this manner, but I started my early investing days as a value investor). Today, I still hold stocks in those companies, and that initial contribution is now worth over $6,500. Over the years, I tried to contribute to it when I could, but I wasn’t always consistent. Some years, I didn’t even contribute at all. And yet, here we are, 12 years later, and I have more than $92,000 in my Roth IRA (and that’s taking into account the 2009 financial crisis when the stock market dropped by 33%)! My total contribution? Less than half of that. If you don’t currently have a Roth IRA or don’t fully understand why a Roth IRA is beneficial, I hope that after reading this post, you will be convinced to get one. A Roth IRA is one of the greatest ways to save money—and not just for retirement!
Let’s take a look at the projected growth of the amount I currently have saved in my Roth IRA. Assuming I don’t add another penny to this account, a conservative 6% return from the stock market (the Compounded Annual Growth Rate of the stock market is about 8% after adjusting for inflation), and I don’t touch this account until I’m 65 (31 years from now), that $92,000 would turn into $560,105–all from just a total contribution of about $40,000.
If I continue to contribute $5,500 a year to my Roth IRA account, my balance at 65 would instead be $1,026,515.
With very little effort, I’d be a millionaire. This doesn’t even take my TSP (401(k) equivalent), the amount in my taxable accounts, or any of my husband’s money into account. The key is to start early.
Imagine two savers, one named “Early Bird” and the other named “Late Bloomer”.
Early Bird invests $5,000 a year between the ages of 25 and 35. In total, she invests $50,000.
Late Bloomer invests $5,000 a year between the ages of 35 and 65. In total, he invests $150,000.
At 65, Early Bird will have $602,070. Late Bloomer will have $540,741, even though he contributed three times more.
This textbook example is not that far from reality. I could easily fit the description of Early Bird, while my husband could be Late Bloomer. It’s why every time we check our portfolios, my portfolio is growing at a much faster rate than his–all because I started sooner.
By harnessing the power of compound interest, Early Bird will have contributed just a third of what Late Bloomer contributed, but end up with a larger portfolio.
Compound interest is truly a powerful force. Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” This is how the rich build their wealth and maintain it—through investing and taking advantage of compound interest to further grow that money. It’s why I started early and why just a couple of years after I started contributing to my Roth IRA in 2005, I opened an account for my younger brother.
A couple of years ago, I was talking to an old college friend about saving and investing. When he realized that I had been doing it since college, he asked me why I didn’t tell him about it sooner. He regretted not starting earlier. Money is something that people just don’t usually talk about, but I’m hoping to change that conversation.
There is an old proverb that I like to share with people who regret that they had not started saving sooner: “The best time to plant a tree was 20 years ago. The second best time is today.” It’s not too late to plant that tree. If you’re in your early 30s, you still have 40+ years for that money to grow. And it can start with a Roth IRA.
So here’s a primer on Roth IRAs and how it can benefit you.
1. What is a Roth IRA?
An Individual Retirement Account (IRA), as the name implies, is a type of retirement account that is intended to help you save for retirement.
How an IRA Differs from a 401(k)
Under a 401(k), your employer has selected a company to administer the retirement plan. The company that administers the 401(k) will typically have a menu of investments that you can select from, so the mix of stocks and bonds that you can buy may be limited, with fees already built-in. Unlike a 401(k), an IRA/Roth IRA is an Individual Retirement Account; it is not sponsored by an employer, so you have full control over the bank or brokerage that you select to be your account custodian and what you select as your investments. The biggest benefit to having full control over your account is the ability to minimize the fees on your account, which are often hidden and can exceed 3%! 3% may not sound like much, but on a $1,000,000 portfolio, that’s $30,000 that you would be paying–every year. High fees will also eat away at your investment growth. It’s like a worm eating away your crop if you were a farmer, which can prevent your crop from growing at its full potential. The downside to having full control is that many people don’t fully understand investing, so they don’t know how to invest their money for the best return possible. For most people, a low expense index fund is the best choice.
Under a 401(k), you can contribute up to $18,000 for 2017 ($18,500 for 2018), whereas the max that you can contribute under a Roth IRA is $5,500 for 2017 (and also 2018).
If you had a 401(k) through your employer, when you leave your job, you have the option of keeping it with your employer or rolling it over to a traditional IRA, since they were both funded with pre-tax dollars. From the traditional IRA, you can then convert it to a Roth IRA, but you must pay taxes on the conversion to turn those funds into after-tax dollars. You will need to plan the conversion carefully to ensure you don’t get hit with a large tax bill.
The other option is to keep the 401(k) with your previous employer and continue to use the brokerage that they’ve selected as the custodian. To determine whether or not you should roll over your 401(k) account to an IRA, you should check your account statements for the account fee (sometimes these fees can be hidden). Account fees that are over 0.50% are too high and you should consider rolling over your 401(k) to an IRA at a brokerage of your choice. These days, there are free online programs that make it easy for you to analyze the account fee on your retirement accounts. My personal favorite is Personal Capital, a free online program that not only analyzes your fees for you, but can also aggregate all of your accounts in one place and let you know if you’re on track to retiring by a certain date.
The Two Types of IRAs
There are two primary types of IRAs: A traditional IRA (commonly referred to simply as an IRA) and a Roth IRA.
Generally, the difference between the two is when you are taxed—before or after. If you are eligible for a tax deductible IRA, you would contribute with before-tax dollars, but you will be taxed when you withdraw this money. With a Roth IRA, you contribute with after-tax dollars (i.e., your take-home pay since your paycheck has already withheld the taxes), but the contributions AND earnings can be withdrawn tax free when you are 59-1/2. (401(k)s and Roth 401(k)s work in the same way.) An easy way to think of the two is, imagine that you are a farmer and the IRS has given you a choice on how your business will be taxed. Under a traditional IRA, you would get to deduct the cost of your seeds on your tax return ($5,500, if you are eligible for the maximum deduction for 2017 and are under 50), but you would have to pay taxes on the value of your crop once it matures and is ready to be harvested. Under a Roth IRA, you would pay taxes on your seeds now, but once the crop is ready to be harvested, you pay no taxes on it.
If you started early, your crop value, when it is ready to be harvested, could easily exceed $1,000,000. So would you rather pay taxes on the seeds or the mature crop? Paying taxes on the seeds typically work out to be a better deal for most people, particularly those who anticipate making more as they progress in their career and will be retiring in a higher tax bracket.
Within the traditional IRA, there is actually a third type of account: a non-tax deductible IRA. There is no income limit to contribute to this type of account, but you would be taxed on the contributions and withdrawals (if you were a farmer, that means that you would be taxed on both your seeds AND the crop). There is a way to minimize your taxes; however, so that you are not taxed on it twice in full. I will go over it in more detail when I explain how high income earners can still contribute to a Roth IRA.
Benefits of a Roth IRA
The great thing about Roth IRAs is, you don’t have to use it just for retirement or wait until you are age 59½ to withdraw money from it. You can withdraw the contributions you made to your Roth IRA at any time without having to pay taxes or penalties since you already paid taxes on it when you contributed that money. Under the following situations, you could also withdraw your earnings tax-free (contributions are the funds you contributed to the account and earnings are the growth on those contributions through capital gains and dividends):
– You use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
– You use the withdrawal to pay for qualified education expenses (e.g. college tuition).
– You’re at least age 59½, provided your account has been open for five years (also known as the “5 year rule”).
– You become disabled.
– You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.
– The distribution is made in substantially equal periodic payments (good for people who are planning to retire early).
– You pass away, in which case, your beneficiary would inherit the account tax-free (they can withdraw the contributions immediately tax-free, but they will also need to meet the five year rule to withdraw the earnings tax-free, i.e. your Roth IRA must have been open for at least 5 years).
And here’s a bonus that many do not know: You don’t have to use your Roth IRA to buy just stocks or bonds. If you wanted to, you could invest in real estate, cryptocurrency (Bitcoin, anyone?), foreign currency exchange, or another asset class. While some people do use their Roth IRAs to buy rental property, I don’t find it advantageous enough because you wouldn’t be able to take advantage of the depreciation deduction in your taxes—which can greatly reduce your overall tax liability and increase your return on investment (ROI). Bitcoin is too speculative for me (ever heard of the Dutch Tulip Bubble?). For these types of investment, you would use a Self-Directed Roth IRA, which is not as mainstream, so you would have to research the different account custodians and the fees involved with opening an account with them.
Whenever friends or family ask me what I’m planning to do for my son’s college savings, I tell them I don’t have a separate account, such as a 529, set up for him (at least I haven’t been convinced yet). Why restrict yourself to an account that can only be used for college expenses when you don’t even know if your child will go to college and risk the penalties? Plus, 529s affect financial aid determination more than assets held by a parent (student assets are counted at 20% compared to only up to 5.64% for parental assets). By the time that my son is ready for college, the money in my account will have more than doubled, and he would easily have over $200K for college. If he pulls a Mark Zuckerberg, drops out of college, and becomes a billionaire, I could use that money towards something else. Do you see why you should prioritize having a Roth IRA over a college savings account? You have a lot more options on how to spend that money. And if you’re married and your spouse puts away another $5,500, that’s double the amount that you can save for your child’s college expenses, a down payment, or your retirement.
2. How much can you contribute to it and what are the eligibility requirements?
To be eligible, you or a spouse must have earned income (if you are a stay-at-home-mom or dad—you can still contribute based on your spouse’s income, but you must file your tax return jointly). Your contribution amount cannot exceed your taxable income, so for example, if you only made $4,000 in 2017, you can only contribute up to $4,000 (this was my case when I contributed to my first Roth IRA–I was a student and only worked during the summer so I had very little earned income). For 2017 contributions, you actually have until the day that taxes are due to contribute to your account, which is April 17, 2018. Just make sure you select the 2017 account to fund.
The contribution limit for a Roth IRA for 2017 (and 2018 as well) is $5,500 or $6,500 if you are age 50 or older. From time to time, the IRS will increase this limit (when I started contributing in 2005, the maximum contribution limit was $4,000). If you are single, your modified Adjusted Gross Income (AGI) must be less than $118,000 and if you are married filing jointly, your modified AGI must be less than $186,000. If you are single and make anywhere up to $18,000 over this amount, the easiest way to lower your AGI is to max out your 401(k) ($18,000). If you make more than $118,000 and/or don’t want to max out your 401(k) contribution, there’s another way around it called the Backdoor Roth IRA.
3. What if you make too much? The Backdoor Roth IRA for high earners.
The Backdoor Roth IRA is the method that high earners (single people with an AGI over $118,000 or married couples filing jointly with an AGI over $186,000) would use to contribute to a Roth IRA. As I mentioned above, high earners would not be able to contribute to a Roth IRA directly, but there is no income limit to contribute to a non-deductible traditional IRA, then converting the IRA to a Roth IRA. Here’s how it works:
You contribute money to a traditional IRA, sell all of the shares, then use that money and deposit it into a Roth IRA account. This has to be done within 60 days of receiving that check from your brokerage or it will be considered a distribution, which may result in taxes and penalties. The other option is to convert an entire traditional IRA account to a Roth IRA account, which your brokerage will be able to help you with. Experts disagree on how long you should wait after you contribute to the traditional IRA account before converting it. The longer you wait, the greater the chance your account will have accrued earnings, which would increase your taxable amount come time for the conversion. The IRS has stated that there is no caveat on a waiting period, so in theory, 1 day would work, but personally, I am more comfortable with 30 days just to give it a clear separation.
Things to watch out for:
If you have both an existing traditional deductible IRA and a non-deductible IRA, the IRS will tax you on the pro-rated amount of the deductible IRA for the conversion. For example, let’s say you have the following accounts:
Existing Deductible IRA: $11,000
New Non-Deductible IRA: $5,500
Total value of IRA: $16,500
If you converted the entire value of the IRA, or $16,500, to a Roth IRA, you would have to pay taxes on the $11,000 since it was funded with before-tax dollars.
But if you only wanted to convert a portion of your traditional IRA, say $5,500, the IRS would tax 66.6% of that, since the prorated taxable portion of $16,500 is $11,000, or 66.6%. The best way to avoid this is to convert any pre-existing IRAs to a Roth IRA before you do the Backdoor Roth IRA. This should be planned in advance to minimize your taxes.
If you are doing the Backdoor Roth IRA for the first time and don’t have any existing traditional IRAs, you don’t have to worry about this.
4. How do you open one?
To open an account, you just need to select a bank or brokerage to hold your account. You don’t need a financial advisor for this—it’s like opening a saving account, but for retirement savings. Some brokerages do have a minimum to open an account, so make sure you check on that.
If you don’t have $5,500 to contribute all at once, you can break it up into biweekly or monthly contributions depending on how often you receive your paycheck. Do try to max out your Roth IRA because once that year is gone, your opportunity to contribute to it is also gone. $5,500 comes out to $211.54 every two weeks, or just $15.07 a day, that you have to save.
My personal recommendation for a brokerage, if you don’t have one already, is Vanguard. Vanguard is owned by its funds, which in turn, are owned by its shareholders, thereby making their interests aligned with yours, which is a rarity in the investment world. (This is not an affiliate or paid endorsement, they really are among the best brokerages.) Both my Roth IRA and taxable account are with Vanguard. If you have Fidelity, Schwab, or TD Ameritrade—those are reputable, too and have a good offering of low-expense index funds that are either free or cost very little in commission to buy and sell. Vanguard does have an account fee of $20, but they’ll waive that fee if you sign up to receive communication (i.e., statements, annual privacy notices, confirmations, and fund reports and prospectuses for mutual fund) electronically. Below is the step-by-step guide to open an account with Vanguard. The other brokerages will have a similar process.
Before you begin, here’s what you’ll need to have handy:
- The routing and your account number at your bank (if not already on file).
- Your current employer’s name and address (required by law).
- Your social security number.
1. Go to Vanguard at https://investor.vanguard.com/home/.
2. Click on “OPEN AN ACCOUNT” at the top of the screen.
3. Click on the red button “Open a new account”.
4. The next screen wants to know how you will fund the account. For most people, it will be “Check or transfer from my bank or another Vanguard account,” but select the answer that applies to your situation.
5. If you are already registered with Vanguard, you would log in on the next screen. I will assume that you don’t have a Vanguard account. Select “No” then click “Continue”.
Note: If at any time you don’t understand something or get stuck during the application, you can call Vanguard for assistance. They are really helpful and can answer any questions you may have.
6. This next screen just tells you what you’ll need to have ready and the process for opening an account. Click “Continue”.
7. For the next screen, for the question “Why are you investing?” you’ll want to select “Retirement”. You will have the option to select an account type. Select “Roth IRA” (unless you qualify for the tax deductible IRA or are a high earner doing the Backdoor Roth IRA, then you would select “IRA” instead) then click “Continue”.
(Note for high earners doing the Backdoor Roth IRA: You would come back after you’ve opened the Traditional IRA to open a Roth IRA for the conversion. Follow the same steps above, but log into your account in Step 5 above.)
8. Enter your personal information in the next screen, then click “Continue”.
10. Complete your mailing address, then click “CONTINUE”.
11. a. Select your employment status. Once you click “Employed,” additional fields will show up for you to complete. Answer the three questions (for most people, the answers will be “No,” but select the responses base on your actual situation.)
b. Fill out your employment information.
12. a. Next, you will fund the account. This is an optional step. If you want to add money later, you can select “Add money later”. I would recommend adding your banking info. now so you can get all set up and ready to go. Click “CONTINUE” once you’ve filled out your funding information.
b. For most people, the answer to this next question is “No” unless you are rolling over an employer sponsored plan, such as a 401(k). Enter the amount you want to contribute, then click “CONTINUE”.
13. You have a choice in reinvesting your dividends and capital gains or holding it in a Money Market Account. I would recommend selecting “Reinvest” to have your money reinvested. This allows your money to be reinvested back in the stock market instead of sitting in a Money Market Account that earns very little.
14. Finally, review all the information that you’ve entered, then submit the application by clicking the “SUBMIT” button at the bottom. After this step, you will be able to set-up your log-in information for online access, which I highly recommend doing.
15. Congratulations! Your account is all set up and if there are no issues, you can start investing and start building wealth! Make sure you change your communication preference to receive documents electronically so Vanguard will waive the $20 account fee.
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DISCLAIMER: I am not a tax professional or financial advisor. The information provided here is for education purposes only. Before making a decision that can affect your tax liabilities and/or personal investments, please consult with a licensed professional who is able to take a look at your complete situation and advise accordingly.