Opening a Roth IRA might be the single best retirement decision you can make. While the Roth IRA doesn’t offer immediate tax gratification as other types of retirement accounts do, it does give you tax-free growth and you’ll never have to pay any taxes if you follow the rules.
A Roth IRA itself is not an investment. David Littell, professor of retirement income at The American College of Financial Services, says that is one of the biggest myths of retirement savings and he hears it all the time.
“The Roth is just a tax vehicle that you can set up with a financial institution,” he says. “You still have to pick the underlying investments, which can be mutual funds, a self-directed brokerage account or an annuity product.”
“The Roth IRA is just the ‘protective shield’ that keeps money in a tax-advantaged bubble,” says Greg McBride, CFA, Bankrate’s chief financial analyst.
Roth IRAs are most commonly funded with stocks, bonds, mutual funds, exchange traded funds or ETFs, and money market funds.
How do I qualify for a Roth IRA?
The sooner you start a Roth IRA the better. But the fact is, you need to be old enough to earn an income and your income cannot exceed certain limits. Contributions for 2020 cannot exceed the lesser of your earned income or the $6,000 contribution limit.
Underage kids can contribute to a Roth IRA, as long as they have income — perhaps a lawn-mowing or snow-shoveling business. They will need a parent or another adult to open a custodial Roth for them and document their earnings. Parents or grandparents can actually contribute the amount of a child’s earnings to a Roth IRA as a gift. When the child reaches adulthood (age 18 or 21, depending on the state), the monies in the custodial account can be transferred into a Roth account in his or her own name.
At the other end of the age spectrum, you’re never too old to invest in a Roth. Even if you’re in your eighties or nineties, you can contribute to a Roth as long as you’re still earning money.
A big plus is that while you are never forced to take withdrawals from the Roth IRA during your lifetime, you generally can always withdraw the contributions if you need to.
How to set up a Roth IRA
The IRS stipulates that an account or annuity must be designated as a Roth IRA when it is opened. You can open a Roth account online or in person at any number of places — mutual fund firms, discount brokerages, full-service brokerages, financial planning firms and robo-advisers, to name a few.
Bankrate’s brokerage reviews provide thorough analyses of the services available at many of the bigger players.
But before you consider where to open an IRA, the first step is to determine whether you want to select investments for the Roth yourself or if you’d rather hire someone to do this for you.
“When you’re talking about younger people, there are do-it-yourselfers, there are people who want investment advice, and there are people who want more comprehensive financial advice,” says Littell.
A young person saddled with student loans or a young married couple with children may need financial planning with a credentialed adviser, such as a professional certified financial planner. A financial adviser can also help an individual who may have trouble staying on course when the market suddenly drops.
“For young people who just need investment advice, you’d be crazy not to consider low-cost advice to help you with asset allocation,” Littell says.
Such advice abounds on the internet for free. You can spend a couple of hours determining the right mix of investments — also known as asset allocation — for your age, time horizon and risk tolerance, or simply select a target-date fund, which has an asset allocation mix suitable for your age and is designed to become progressively more conservative as you reach retirement age. The target date can be 10, 20 or 40 years into the future, ideally the time when you expect to begin taking withdrawals.
Thousands of advisers and financial institutions are vying for your dollars, but it’s not rocket science to get started. It’s a matter of your knowledge level and personality style, Littell says. “The more you want to be hands-off, the more you probably need an adviser. Robo-advice is not so hands-off.”
But robo-advisers are marketed as hands-off investment options. Robo-advisers are automated online investment portfolio services that generally charge a smaller fee than you would pay for human advice. Management fees range from nothing at all to 0.50 percent of assets or more, and while some robo-advisers do not require a minimum balance, others require a hefty one, with the latter generally providing human advice if needed.
Where to open a Roth Account
Step two of how to open a Roth IRA is to determine where you will open your Roth account. Look for a firm that offers commission-free (or no-load) mutual funds or ETFs and charges no fees for account maintenance, initial investments or account transfers.
Competition among brokerage houses has resulted in no fees for stock trading. But this should not be a big priority for young people. “Novice investors should avoid trading stocks and instead invest in broad-based, low-cost index funds, and do so on a commission-free platform,” says McBride.
Littell says to check the reviews at the various financial entities you’re considering. “Also, consider what types of education they can offer and tools, like calculators and other useful tools. And consider fees.”
Choosing investments for a Roth IRA
Step three of how to open a Roth IRA is choosing the investments for it. Even if you do hire an adviser, you should review the investment recommendations and inquire about fees.
Whether you are a do-it-yourselfer or a delegator, you will almost always pay an expense ratio for the fund or ETF you choose. Advisers generally charge a fee on top of that.
According to Morningstar, the average expense ratio for a passive index fund is 0.15 percent, versus 0.67 percent for an actively managed fund, run by a fund manager whose intent is to beat the market. However, few managers can sustain market-beating returns over the long term.
“The less an investor pays in fees, the more money that stays in the account,” says Bankrate’s McBride. “Higher fees do not translate into better performance and are a handicap to achieving it. There’s nothing wrong with choosing low-cost index mutual funds or ETFs.”
Low-cost index funds that mimic the stock market make the most sense for young investors just starting out. Vanguard, which manages $5.6 trillion in assets, is known for its lineup of low-cost index funds, but competitor Fidelity Investments, with $3.2 trillion of assets under management, also offers cheap index funds, including four with a 0% expense ratio and no minimum investment requirement.
How much interest will I earn on Roth IRA?
“What you earn in your Roth IRA will depend on the investments you choose within it,” says McBride.
Littell’s advice to younger people is to invest primarily in stock funds. “The longer your investment horizon, the more risk you can afford to take. So we encourage younger people to have a higher allocation to equities.”
But how much your account earns depends on both the fees you pay and how your investments perform. Because annual asset management fees are deducted from your account balance, it will act as a drag on your total return. Of course, you will accumulate more money if the investments perform well and less if they do poorly.
The table below illustrates the difference that a 1 percentage point in return can make in how much an investor accumulates after contributing $500 a month to a Roth IRA for 30 years. That percentage point loss can be attributed to higher expenses or to subpar returns due to choosing a poorly performing investment.
Portfolio return Assets accumulated after 30 years*
* Assumes $500 monthly payments were made at the beginning of each month for a period of 30 years.
How much money do I need to open a Roth IRA?
Different firms require different minimum investments, but most online companies usually have no minimum. Others will waive them if you set up automatic monthly contributions. Regular contributions are smart to do because once you set this up, you don’t have to think about it except maybe once a year, when you might increase the investment amount if the IRS raises the contribution limit. Your account will automatically build over time,.
Because the 2020 contribution limit is $6,000, that’s the most you can contribute over the course of a year. If you can afford to contribute $500 a month, you will reach the limit after 12 months. The IRS also allows you to contribute to last year’s IRA, and you have until mid-April, when taxes are due, to invest for the previous calendar year. For example, you can make contributions for the 2019 tax year right up to April 15, 2020. Then for 2020’s contributions, the deadline is tax day in 2021.
Of course, if you can’t contribute $500 a month, contribute what you can. In the end, Littell says, “contribute and invest over the long haul and investors will get gobs of tax-free growth.”
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