Roth IRA: What It Is and How to Use it Effectively

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. Sounds fairly good right?

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.

Up to this point, the Roth IRA is sounding pretty good. Your investments within the account grow tax free and then you get to pull the money out tax free in retirement. How can you beat that? Well, hold your horses. Since the Roth IRA offers these tax benefits, the IRS has rules and qualifications you must follow or meet to open and use a Roth IRA.

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.

If your income is too high that you are not able to use a standard Roth IRA, you can get around the problem by using a Backdoor Roth IRA instead.  

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.

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.

The short answer is that it depends. A Roth IRA is one of the best investing accounts available, but it is not necessarily the end all, be all of investing accounts. It might be advantageous to use the Roth IRA in tandem with other investing accounts. (We will look at that in a bit). With that being said, you can compare the advantages and disadvantages of the Roth IRA below to see if you should use it.

Advantages of the Roth IRA

1) Tax benefits

The main advantage to a Roth IRA is the tax benefits. Although you do have to pay taxes on the dollars you contribute today, knowing that your money will grow tax free and that you won't have to pay taxes when you pull the money out in retirement is huge.

2) Investment options

Unlike certain retirement accounts that limit what you can invest in (such as 401ks), the Roth IRA allows you to invest in a wide range of assets. You can hold individual stocks, mutual funds, index funds, bonds, real estate investment trusts and more in a Roth IRA.

3) Accessibility

Although it is not recommended to pull money out of your investing accounts, you do have the option to withdraw base contributions from a Roth IRA. If you get in a financial pinch and the dollars in your Roth IRA will prevent you from going into bad debt such as credit card debt, knowing you can take money out of a Roth IRA as a last resort can be advantageous.

Disadvantages of the Roth IRA

1) Eligibility

In a perfect world, everyone would be able to open and use a Roth IRA. However, the IRS is not that friendly. Due to the tax benefits, your income needs to be below a certain level to use a Roth IRA. The income limits are still fairly high meaning that most people can use a Roth IRA. However, if you don't qualify for a Roth IRA, you will have to use other accounts such as a Roth 401k, Traditional 401k or brokerage account to save for retirement.

2) Lower contribution limits than other investing accounts

If you qualify for a Roth IRA, you would want to be able to contribute as much as you like. But again, the IRS does not want to give you too much of a good thing. When compared to other retirement accounts such as a 401k, the Roth IRA does have lower contribution limits. In other words, you cannot contribute as much to a Roth IRA as you can to other investing accounts.

Again, the answer is that it depends, but a good place to start is with investment funds. An investment fund pools the resources of many investors and uses that money to buy a variety of assets including stocks and bonds.

Stocks typically make up the majority of most investor's portfolios. However, trying to choose individual stocks for the every day investor will be almost impossible. That is where an investment fund can come in handy. Investment funds allow you to invest in hundreds of stocks all at once.

This means that your exposure to risk would be lower than if you were to hold just a few individual stocks within your Roth IRA. If one of the stocks in an investment fund does not perform well, the other stocks in the investment fund can make up for it.

Investment funds, such as mutual funds, index funds, and etfs allow you to have a diversified portfolio, while also having the opportunity to experience high returns. Some investment funds can average 10%, 11% or 12% returns per year. These high returns can significantly increase the value of investment funds over time in your Roth IRA.

For example, let's say that you opened a Roth IRA at 25 years old and were planning on retiring at 65. Let's assume that you can earn a 10% return per year on the investment funds in your Roth IRA and can contribute the maximum amount of $7,000 per year. When you retire, you could potentially have just over $3 million in the account.

The green line on the chart above shows how much you contributed to the Roth IRA over those 40 years ($279,840). The red line shows how compound interest grew the value of the investment funds you held in your Roth IRA over those 40 years.

Keep in mind that investment funds don't always go up in value. Since these funds are made up of stocks and bonds, the value of the fund can go up, down, sideways, and crash. If you decide to hold investment funds in a Roth IRA, you need to invest in both good times and bad since investment funds tend to perform well over long periods of time, and not always in the short term.

Potential investment funds to hold in a Roth IRA - The Fidelity 500 Index Fund (FXAIX). The Fidelity Zero Large Cap Index Fund (FNILX). The Schwad S&P 500 Index Fund (SWPPX). The T. Rowe Price US Equity Research Fund (PRCOX). The Massachusetts Investors Growth Stock Fund (MIGFX). The BlackRock Exchange Blackrock Fund (STSEX). The State Street US Core Equity Fund (SSAQX).

Important note: Keep in mind that these investment funds are only examples of what you could invest in and should not be taken as strict financial advice. The investments that you should hold in a Roth IRA could be different that those discussed above. We recommend speaking with a licensed financial advisor if you need help choosing investments for your Roth IRA.

Step 1: Open a Roth IRA

The first step to using a Roth IRA is to open the account. This is an easy process that can be done through either an online broker or robo advisor. Go to the website of your broker or robo advisor and fill out an application online.

Once your application is approved, you can transfer money from your bank account to your Roth IRA to buy your investments with. If you need more help opening a Roth IRA you can check out our guide on how to set up a Roth IRA.

Step 2: Buy investment funds to hold in your Roth IRA

Remember, a Roth IRA is not an investment itself. It only holds your investments. We note this because most people open a Roth IRA, transfer money from their bank account and think they are investing. However, there is one more step.

You need to take the money within the account and then buy your investment funds. You can do this by searching for your desired investment funds through your broker, choosing how many shares you want to buy, and then buying those shares.

Step 3: Max fund the Roth IRA

If you are able to, you should try to max out your Roth IRA. Remember, you can contribute $7,000 per year or $8,000 per year if you are 50 and older. The more you can contribute to a Roth IRA, the more investments you can buy, the more your money will grow over time.

Step 4: Use the Roth IRA in tandem with other investing accounts

Finally, you can use the Roth IRA in tandem with other investing accounts. The Roth IRA has loads of benefits, but using the account in tandem with other investing accounts is where the gold is. You can mix a Roth IRA with a workplace plan such as a Traditional 401k, or another investing account like a  brokerage account.

The bottom line is that the Roth IRA is a great investment account to use for your retirement. You pay taxes on the dollars you contribute today, but then get to enjoy tax free withdrawals in retirement. The account does have some rules such as eligibility, contribution limits, and withdrawal rules.

However, these rules that you must follow don't outweigh all of the benefits offered by the Roth IRA. Holding investment funds in a Roth IRA can be a good investment to put into the account when you are just getting started. If you want a broad overview on investing, you can check out our guide on how to invest for beginners.