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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 on withdrawals if you follow the rules.
If you’re looking to open a Roth IRA, here’s how to get started.
How to set up a Roth IRA
1. Find out if you’re eligible for a Roth IRA
If you’re interested in contributing to a Roth IRA, you have to fulfill two major conditions:
- You need to have earned income, such as from a job.
- Your income cannot exceed certain limits.
To qualify for a Roth IRA your income must be below specific levels, if you want to take full advantage. If it does exceed those levels, your ability to contribute will phase out up to a certain level and then be eliminated completely. So your income must be below the top end of the phase-out levels to take advantage of the Roth IRA at all.
The income limits below apply to your modified adjusted gross income.
|Filing status||Income limit and phase-outs (for 2021)|
|Single, head of household or married filing separately (if you didn’t live with your spouse at any time during the year)||
|Married filing jointly, qualifying widower||
|Married filing separately (if you lived with your spouse at any time during the year)||
For example, if you’re a single filer and your modified adjusted gross income is $110,000, you’ll be able to take full advantage of the Roth IRA (since it’s below the $125,000 limit). However, if it’s $130,000, you’ll be able to contribute only part of your annual limit directly to a Roth IRA.
However, it’s still possible to wiggle around these income rules by using a backdoor Roth IRA.
Underage children can contribute to a Roth IRA, as long as they have income, perhaps through 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 money 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.
2. Figure out how you want to manage the account
Before you consider where to open an IRA, you’ll need to determine whether you want to select investments for the Roth yourself or if you’d rather hire someone to do it 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 David Littell, professor emeritus of taxation at The American College of Financial Services.
If you’re looking to do it yourself, a broker might be the best option for you. But you’ll need to have a solid understanding of investments before you start.
“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 more conservative as you reach retirement age. The target date can be 10, 20 or 40 years in the future, ideally when you expect to begin taking withdrawals.
Others may need the help of a professional. A young person saddled with student loans or a young married couple with children may need financial planning with a credentialed advisor, such as a certified financial planner. A financial advisor can also help an individual who may have trouble staying on course when the market suddenly drops.
Robo-advisors can be a good choice for those who want a “do it for me” solution, too.
Robo-advisors are automated online investment portfolio services that generally charge a smaller fee than you would pay for human advice. Management fees typically range from nothing at all to 0.40 percent of assets, and while some robo-advisors do not require a minimum balance, others require a hefty one, with the latter sometimes providing human advice, if needed.
3. Pick where you’ll open your Roth IRA
Step three of how to open a Roth IRA is to determine where you will open the account.
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-advisors, to name a few. The IRS stipulates that an account or annuity must be designated as a Roth IRA when it is opened.
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.”
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 commission-free trading, which is a great thing for those just getting started. More of your money stays in your investments instead of going into the broker’s pocket.
Bankrate’s brokerage reviews and robo-advisor reviews provide thorough analyses of the services available at many of the bigger players. You can get a comprehensive look at what’s available and what might be best for you.
4. Choose investments for a Roth IRA
The next step in opening a Roth IRA is choosing the investments for it, whether you’re doing it all yourself or having someone do it for you.
A Roth IRA itself is not an investment, says Littell. “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 chief financial analyst.
Roth IRAs are most commonly funded with stocks, bonds, mutual funds, exchange-traded funds or ETFs, and money market funds.
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. Advisors generally charge a fee on top of that.
“The less an investor pays in fees, the more money that stays in the account,” says 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.”
Even if you don’t pick investments yourself and hire an advisor, you should review the investment recommendations and inquire about fees.
5. Set up a contribution schedule
Finally, it can make a lot of sense to fit regular IRA contributions into your monthly budget, rather than try to make the whole contribution in one lump sum. If you can afford to contribute $500 a month, you’ll reach the $6,000 annual contribution limit (for 2021) in 12 months.
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.”
Regular contributions are a smart strategy, because once you set them up, you don’t have to think about them, and your account will automatically build over time. Plus, if you’re investing regularly you can also take advantage of dollar-cost averaging and reduce your risk.
What is the best way to invest my Roth IRA?
“What you earn in your Roth IRA will depend on the investments you choose within it,” says McBride.
A Roth IRA gives you a lot of investment options, but those with a long time until retirement should consider being more aggressive with their investments.
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.”
For context, a plain vanilla index fund based on the Standard & Poor’s 500 index has returned about 10 percent annually on average. But those returns fluctuate a lot from year to year, and stocks can sometimes be very volatile.
How much your account earns depends on both the fees you pay and how your investments perform. Because fees for mutual funds and ETFs are deducted from your account balance, they 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 could 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.
This Roth IRA calculator can help you see how much you could amass tax-free.
How much money is needed to open a Roth IRA?
Different firms require different minimum investments, but most online brokers or robo-advisors usually have no minimum to open a Roth IRA. Others will waive them if you set up automatic monthly contributions.
The annual contribution limit for 2021 is $6,000, so that’s the most you can contribute over the course of a year, though those over age 50 can contribute an extra $1,000 each year.
However, contributions cannot exceed the lesser of your earned income or the annual limit.
The IRS also allows you to contribute to last year’s IRA up until Tax Day of the following year. For example, you can make contributions for the 2021 tax year right up to April 15, 2022. Then the deadline for 2022’s contributions is Tax Day 2023.
Can you transfer a pre-existing 401(k) into a Roth IRA?
If you have an employer-sponsored 401(k) plan, you can roll over that account to an IRA (Roth or traditional) when you leave your employer. However, the move could create tax liabilities.
If you’re moving from a traditional 401(k) to a traditional IRA, you generally won’t encounter tax issues from the move, because both accounts are made with pre-tax contributions. Similarly, if you’re rolling over a Roth 401(k) to a Roth IRA, you generally won’t encounter tax issues, since both accounts are funded with after-tax contributions.
But if you roll over from a traditional 401(k) to a Roth IRA, you will likely generate taxes. That’s because you’re moving contributions that have never had tax paid on them to an account that requires after-tax contributions. So you’ll have to pay those taxes during the rollover process.