How Do I Set Up a Roth IRA?

A Roth IRA, or individual retirement account, is a type of investing account designed to help you save for retirement. The money that you put into a Roth IRA grows tax free and when you take the money out in retirement you do not have to pay any taxes.  

The idea behind a Roth IRA is to pay taxes now, and then enjoy zero taxes in retirement when you pull the money out. When you contribute to a Roth IRA, you make contributions with dollars that you have already paid taxes on.

However, once those dollars are in your Roth IRA, they grow tax free and you can then withdraw the money tax free in retirement once a couple of rules have been met. The tax benefits make the Roth IRA a very attractive account to use for retirement.

Keep in mind that a Roth IRA is an investing account and not an investment itself. Instead a Roth IRA just holds all your investments. When you open a Roth IRA, you still must put investments within the account. Do not get caught up on what investments you should put in your Roth IRA. We will look at that later.

1) Eligibility

Unfortunately not everyone can have a Roth IRA. The first requirement you must meet is that you must have earned income - such as income from a job to open a Roth IRA. Secondly, your income can't exceed certain levels if you want to open and contribute to a Roth IRA.

If your tax filing status is single or head of household, your modified adjusted gross income (MAGI) has to be $146,000 per year or less to make the maximum contribution to a Roth IRA. If your income is between $146,000 and $161,000 you can contribute a reduced amount to a Roth IRA. However if your income is $161,000 or above, you can't use a Roth IRA at all.

If your tax filing status is married filing jointly or qualified widow(er), your modified adjusted gross income (MAGI) has to be $230,000 per year or less to make the maximum contribution to a Roth IRA. If your income is between $230,000 and $240,000 you can contribute a reduced amount to a Roth IRA. However if your income is $240,000 or above, you cannot use a Roth IRA at all.

2) Contribution limits

Additionally, the IRS also limits how much you can put into a Roth IRA on a yearly basis. The maximum amount you can contribute to a Roth IRA is $7,000 per year of $8,000 per year if you are 50 and older.

Using the eligibility rules above, you may be able to contribute a reduced amount if you don't qualify to contribute the full amount. You can use IRS rules to figure out what your reduced contribution amount would be.

3) Withdrawal rules

Finally, you must meet a couple of rules to withdraw money from your Roth IRA. First, the account must be at least 5 years old. Second, you must be 59 and a half years old. If you try to withdraw the money in your Roth IRA before meeting these rules, you can incur a 10% penalty and additional income taxes.

The exception to this rule is that you can withdraw your base contributions without incurring a penalty. For example, say that you had made the max contribution allowed to your Roth IRA, which would be $7,000 per year if were younger than 50. At any point, you could withdraw that money from your Roth IRA.

However, say that your original contribution of $7,000 had grown in value to $10,000 as the investments within your Roth IRA grew in value. If you tried to take out the $10,000, you could incur a 10% penalty and income taxes on the $3,000 your investments had earned in the account.

Before you can open a Roth IRA, you need to make sure you are eligible by meeting two requirements. First, you must have earned income. Second, your income must be below certain limits. Your income will determine if you can make the maximum contribution to a Roth IRA, which is $7,000 per year or $8,000 per year if you are over 50 for 2024.

If you file your taxes as an individual in 2024:

If you file your taxes as an individual you can make the full contribution if your income is $146,000 per year or less. If your income is greater than $146,000 but less than $161,000, you can contribute a reduced amount. If your income is over $161,000, you will not qualify for a Roth IRA at all.

If you file your taxes married filing jointly in 2024:

If you file your taxes under the married filing jointly status, you can make the full contribution if your income is $230,000 per year or less. If your income is greater than $230,000 but less than $240,000, you can contribute a reduced amount. If your income is over $240,000, you will not qualify for a Roth IRA at all.

Once you have checked your eligibility, you need to decide where you want to open your Roth IRA. There are many options available, but the easiest way to filter them out is by asking yourself a simple question. How do you want to manage the account? To keep things simple, you have two options. You can manage the account yourself, or you can have someone manage the account for you.

Options if you want to manage the account yourself

If you enjoy being more of a hands on investor, you can open your Roth IRA through an online broker or a trading platform. Both allow you to be in complete control of what investments you want in your Roth IRA. Although managing the account yourself does give you control, it can also be challenging to choose your own investments.

Keep in mind that you need to build a diversified portfolio of assets to hold within your Roth. One of the easiest ways to do this would be to build your portfolio with low cost mutual funds, index funds, and ETFs. If you do decide the manage the account yourself, make sure to see what kind of commissions your broker charges so you can keep your costs low.

Options if you want the account managed for you

If you would rather have someone else manage your Roth IRA for you, you have a few options. First, you can have a financial advisor manage the account. Not only can an advisor help you choose investments for your Roth, but they can also build a comprehensive financial plan tailored to your exact needs. Another great option would be to open your Roth through a robo advisor.

A robo advisor is a digital financial advisor that uses algorithms to build you an investing portfolio based upon your goals and risk tolerance. Robo advisors don't build comprehensive financial plans like a financial advisor, but often cost less and are a very easy way to get started.

Thirdly, you need to fill out the paperwork to open your Roth IRA. The process for paperwork will be the same whether you opted to manage the account yourself or are having the account managed by someone else. The good news is that the paperwork can be filled out online. As you fill out the paperwork, have the following on hand.

Wait, I am confused. Isn't a Roth IRA an investment? The short answer is no. Your Roth IRA simply holds your investments. Imagine that your Roth IRA is a grocery cart. You have to place the groceries, or your investments, within the cart. The cart is not an investment itself, but instead holds your investments.

If you opt to open your account through a robo advisor or with the help of a financial advisor, you do not have to worry about choosing your investments as that will be done for you. If you opted to manage the account yourself, you will oversee choosing and placing investments within your Roth.

You can invest in whatever you like, but you need to make sure you are holding a diversified portfolio to lower your risk. A few common suggestions are to invest in a target date fund or a a range of mutual funds. This will allow you to automatically invest in lots of assets at once, which will lower your exposure to risk.

Finally, you need to consistently invest in your Roth IRA to allow your contributions to compound and build wealth. The easiest way to do this is to set up automatic contributions monthly. Review your budget to see what dollar amount you can afford to contribute on a consistent basis.

Ideally, you want to be able to contribute the maximum amount of $7,000 per yer, which breaks down to $583 per month. However if that is not feasible for you, contribute whatever amount you are able. The whole point is to build the habit of investing. You can always up the amount of your contributions later.

If your income is too high, you won't be able to use a Roth IRA. If you find yourself in this position, there are several additional options that can be worth exploring.

1) Use a Traditional IRA

Your first option is to use a Traditional IRA. A Traditional IRA works in the exact opposite way of a Roth IRA. You contribute to the account with dollars that have already been taxed, but may be able to take a tax deduction on your contributions depending on your income and whether or not you contribute to a 401k.

When you pull the money out a Traditional IRA in retirement, you will usually owe taxes. The rules of a Traditional IRA are similar to those of a Roth IRA, but a Traditional IRA does not have an income limitation. This means that if you don't qualify for a Roth IRA, you will qualify for a Traditional IRA.

2) Roth IRA conversion

Your second option would be to do a Roth IRA conversion. A Roth IRA conversion is where funds are transferred from another account, such as a 401k, into a Roth IRA. If you convert funds from an account that gave you a tax deduction, you will owe taxes on the conversion. A licensed financial advisor can help you complete a Roth IRA conversion.

3) Back door Roth IRA

As noted above, you can opt to use a Traditional IRA if you don't qualify for a Roth IRA. A back door Roth IRA is a way to get a Roth IRA if you do not qualify. You would make nondeductible contributions to a Traditional IRA and then convert it into a Roth IRA. A licensed financial advisor can help you complete a back door Roth IRA.