When most people think about investing, the last thing that comes to their mind is their retirement savings. However, retirement should be on everyone's radar, as a relatively small investment at a young age can grow into much larger sum later, after decades of compounding.
One of the easiest places to stay? A Roth IRA.
What is a Roth IRA?
A Roth IRA is a retirement account that offers some really valuable tax benefits, including tax-free growth on your investments. As a teenager or young adult, time is your best friend.
Let's check it out:
Let's say that for every year from 25 - 65 you invest $5,000 in your Roth IRA at an 8% return. By the age of 65, you would have a portfolio balance of approximately $1,400,000 - tax free upon withdrawal.
Now, if you started investing the same $5,000 at an 8% return from 18 - 65, you would have a whopping $2,400,000 - all without having to pay additional taxes.
So how does a Roth IRA work?
Basically, a Roth IRA is a retirement account that holds your investments vs. being an investment itself.
Just like how you invest using a brokerage, not in a brokerage. Within a Roth IRA, you can invest in stocks, bonds, exchange-traded funds (ETFs), or bank saving products.
Throughout the year, you can invest up to $6,000, or the amount of earnings income you had that year, whichever is smaller.
That means that if you make $3,000 a year, you can invest up to $3,000 in your Roth IRA.
The important distinction is that what sets your contribution limit is earned income. Let's say you were completely unemployed but had you a great year in the stock market and make $30,000 trading stocks. Unfortunately, you wouldn't be able to contribute that to your Roth IRA because stock growth is passive not earned income.
However, the IRS doesn't exactly care where the money you contribute to your Roth IRA comes from. This means if you had a job paying you $10,000 a year and also made $30,000 in the stock market, you could contribute $6,000 into your Roth IRA even if it wasn't the money your employer paid you.
The IRS sort of just assumes that the money you contribute to your Roth IRA is money paid to you from your employer, even if it came from stock gains. But if you didn't earn anything from an employer, then it's obvious to the IRS the money you're trying to contribute to your Roth IRA wasn't earned income.
What are the Advantages of a Roth IRA?
No Age Limit
One of the best parts of a Roth IRA is that you can open an account at any time in your life as long as you're earning income. If you are under 18, it's a little tricky since you have to open a custodial account, but we'll get to that.
Tax Free Profit
The money that you invest in your Roth IRA is post taxes - and when you turn 59.5 years old, that money is all yours tax free. All of the compound interest that you have earned over the years isn't subject to taxes or fees - only your contributions were taxes.
Compound interest has been described to be the 8th wonder of the world - as explained in our example above, a difference of 7 years of investing between 18-25 ends up being a monetary difference of $1,000,000. If you want to calculate your own rates and investments, check out this Roth IRA Calculator: https://www.bankrate.com/retirement/calculators/roth-ira-plan-calculator/
I'm Sold - How Do I Start?
You've made the important decision to open a Roth IRA - congratulations! Here's how you do it:
Here are a few more places to start:
Charles Schwab: highest customer satisfaction, best overall.
Fidelity: best for beginners / younger users.
Betterment: top robo-advisor (who we recommend if you just want to contribute and forget about it)
If you are under the age of 18 you can still invest in your Roth IRA, but it must be through a Custodial / Joint Roth IRA. Fortunately, signing up for these is just as easy as signing up when you're over 18.
When looking for custodial / joint Roth IRAs, not all banks / robo-adivsors offer them and make sure you talk with your parents about where to sign up.
When you're under 18, you have access to a parent match plan for investing. You can only invest up to $6,000 a year, but if you are investing $2,000, your parents can match your contribution for a total of $4,000 invested.
Charles Schwab, Fidelity, and Vanguard all work great for this.
Things to Remember:
The process is fairly simple, but here are some important things to take note of:
There is a limit to investing
The maximum contribution to a Roth IRA is $6,000 per year. If you are 50 or older, the limit is $7,000.
Investments must be earned income
When you invest in your Roth IRA, your investment must come from wages, salaries, commissions, bonuses, self-employment, freelance, and contract work.
Know what you're investing in
One of the most common mistakes that investors make with their Roth IRA is just putting money in the account without actually investing the money. You likely have decades to invest, take advantage of that opportunity.
ETFs and Index Funds are best for beginners, here are some of our favorites:
A Roth IRA account is one of the best investment decisions you can make for your retirement, and the earlier you start, the more you will earn over time, tax free.