The Roth IRA made easy

Starting a Roth IRA is one of the easiest — and best — steps you can take to save for retirement. But you should understand the Roth IRA rules before investing in them.

I know I've written a lot about the Roth IRA in the past, but I still get questions all the time. People find them intimidating. For example, Lynn wrote last week:

I'm a 36-year-old single mother of two. I want to start investing for my future, but I am so overwhelmed by all the information. I was wondering if you could give me some advice on my best options for a Roth IRA. I am a school teacher and earn $41,000 per year.

I am going to do more research, but I would appreciate some advice from someone who already has expertise in this area. I am not sure what I need to start a Roth IRA, or who I should go with. I don't know much about mutual funds or anything of that sort, so any help and advice would be appreciated.

Let's clear things up: A Roth IRA does not need to be confusing. In fact, a Roth IRA is actually fairly easy to understand.

Note: This post is going to keep things basic. For more detailed info, see the resources at the end of this article, or consult a financial planner.

Roth IRA Basics

The Roth IRA is an individual retirement arrangement: It lets you save and invest for your future. An IRA is simply a holding account. It's a label. When you own a Roth IRA, it contains nothing. It's like a bucket, a place for you to put things. (Most people think of an IRA as an individual retirement account, which is fine, but it's actually an “arrangement.”)

The things you put in your bucket are investments. You might, for example, buy a stock to put in your retirement account. Or maybe government bonds. Or certificates of deposit. The important thing to understand is that a Roth IRA is not an investment — it's a place to put investments.

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With many retirement accounts — such as 401(k)s and traditional IRAs — you contribute pre-tax money and are taxed when you take the money out during retirement. Because they work with after-tax money, earnings from a Roth IRA can be withdrawn tax-free at retirement.

Roth IRA Rules and Requirements

Because Roth IRAs are meant to encourage ordinary people to save for retirement, not everyone qualifies for them. If you do qualify, you can contribute up to $5,000 to your Roth IRA every year. If you're 50 or over, you can contribute $6,000.

Who qualifies? Nearly everyone. However:

  • If your tax filing status is single and you earn more than $105,000 per year, your contributions are restricted.
  • If you're married filing jointly, your contributions are limited if your household earns more than $160,000 per year.

You can use a Roth IRA even if you have a 401(k) or other retirement plan, but you must make your contributions by the tax deadline each year.

The rules are a little more complex than that, but those are the basics. If you need more info, take a look at the resources listed at the end of this article.

Where to Open a Roth IRA

Deciding where to start your Roth IRA is the most difficult part of the process. Many financial institutions offer IRAs. Each has its own strengths and weaknesses. Don't fret about finding the perfect match — find a good match and then get started.

To make things simple, here are four big companies that provide Roth IRAs (though these are by no means your only options):

  • Fidelity Investments offers a no-fee IRA. There's a $2,500 minimum initial investment, but this is waived if you commit to $200/month automatic contributions. They offer 4,600 mutual funds, about a quarter of which have no transaction fee. In short, you can open a no-cost IRA at Fidelity with a $200 starting investment if you invest in mutual funds and you agree to contribute $200/month. Apply for a Roth IRA with Fidelity.
  • It's also possible to open a no-cost Roth IRA at The Vanguard Group if you elect to receive electronic statements. Otherwise, a $20 annual fee is charged until your Roth IRA balance is over $10,000. Your minimum to get started is $3,000 — except that you can start with just $1,000 in the company's STAR fund. (The STAR fund is an mutual fund of mutual funds, a safe choice for beginners.) Additional contributions require a minimum of $100 unless you use their Automatic Investment Plan, in which case the minimum is $50. There are no fees to purchase the STAR fund. Start a Roth IRA at Vanguard.
  • T. Rowe Price charges $10/year for Roth IRA accounts until you have a balance above $5,000, after which there is no fee. You need $1,000 to open your IRA, but this minimum goes away if you sign up to contribute at least $50/month with the Automatic Asset Builder. There are no sales fees or commissions to invest this money in T. Rowe Price mutual funds. Open an IRA at T. Rowe Price.
  • Scottrade resists charging its customers set-up, annual or maintenance fees for its online trading services and also offers them the opportunity to get a refund of up to $100 in transfer fees from other brokers for bringing their Roth IRA to Scottrade. Scottrade's pricing on trades is fairly simple: $7 for stocks $1 and above for online market and limit equity orders. You might also consider a Scottrade checking, savings or money market account. These can be joined with a trading account to help easily fund transactions.

Opening a Roth IRA is easy. You'll need some minimal bank account info and about 30-60 minutes of free time. If you've ever filled out a job application or applied for a credit card, you can certainly open a Roth IRA. Once you've completed your application, you can transfer money to the account. It might have to sit in a money market fund until you have enough saved to buy your first mutual fund, but that's okay. You're developing the saving habit!

Note: I'm a big fan of automatic investment plans. Most of these companies offer some sort of program that will pull money from your bank account every month to invest in stocks or mutual funds that you designate. By setting aside $50 or $100 or $500 in this way, saving becomes a habit.

Which Investments to Choose

Here's where I cop out. I'm not a financial adviser. I don't know your goals or risk tolerance. I can't tell you were to invest.

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And to be honest, where you invest doesn't matter nearly as much as the fact that you do invest. To get some ideas, browse through the investing archives here at Get Rich Slowly. (Maybe start with these “lazy portfolios.”)

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If you're really stressed, pick a target-date fund that most closely matches the year you'll retire. This probably isn't the best option, but it's fine. Just use it while you get in the habit of making contributions. You can always switch the money to something more appropriate later.

Related >> Choosing a Target-Date Fund

Learning More About the Roth IRA

In 2007, I ran a four-part series exploring the benefits of a Roth IRA. If you need more info about these accounts — or if you have questions — you should start here first:

I've revised these articles and compiled them into a free e-book called The Get Rich Slowly Guide to Roth IRAs (518kb PDF). (Note that this e-book was produced in April 2008, so some of the info is a little out of date, especially about Zecco.) And if you want the official word on the subject, check out IRS publication 590, which is all about IRAs.

Now's the part where you can tell Lynn how easy it is to set up a Roth IRA. (And share what sort of things you've invested in.) My own Roth IRA started with stupid stock picks (Countrywide, The Sharper Image) and has moved toward index funds. I'm all about making things easy right now!

More about...Retirement, Investing

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