How Does a Roth IRA Work? In-Depth Guide (2024)

You don’t have to be a millionaire and you don’t have to earn $100,000’s to invest in a Roth IRA.

In fact, if you’re at the beginning of your career and if you are a young professional, then investing in a Roth IRA could be your best next move.

If you want to take advantage of the tax system, then Roth IRAs may be your ticket in.

So, if you’re wondering: “How does a Roth IRA work?” then, you’ve come to the right place!

Acorns, in my opinion, is the best option for the beginner micro-investor.

If you’re starting your investing journey and can’t yet contribute $1,000’s per year, then Acorns may be a good start for you.

With Acorns, all you need is $5 to start investing.

What is a Roth IRA and How Does it Work?

A Roth IRA is a tax-advantaged retirement account that anyone can open. You pay taxes on any contributions you make and in exchange, you won’t have to pay taxes on withdrawals, including investment profits.

If you’re just starting out in your career and if you believe taxes will be higher in the future, a Roth IRA could be one of the best types of investment vehicles for you.

Below is a quick overview of the key features:

IRA stands for:Individual retirement account.

A Roth IRA is a type of individual retirement account.

So, just like:

• Regular investment account
• Checking accounts
• Savings accounts
• 401k accounts

…A Roth IRA is simply the name of an account that can hold your investments.

By investments, I mean that a Roth IRA could have some of the following:

• Cash
• ETFs
• Bonds
• Stocks
• Index Funds
• Mutual Funds

You get the point.

A Roth IRA also means your money is treated differently on a tax basis:

A Roth IRA means that the money you contribute is already taxed – and that you do not receive a tax deduction on your Roth IRA contributions (unlike with a Traditional IRA).

Let’s take your weekly paycheck for example:

Your take-home pay is $1,500.

And as you can see, you’ve already paid taxes.

When you decide to invest in a Roth IRA, you would take a portion of that leftover $1,500 (it’s already been taxed) and put that into your Roth IRA.

Note:You can always take out any of the contributions you put into your Roth IRA at any point in time. That’s because you’ve already been taxed on the contributions.

Who can Contribute to a Roth IRA?

There are 2 main requirements to contribute to a Roth IRA:

1. You must have earned, taxable income
2. You must not exceed the Roth IRA phase out ranges

First, let’s go over what earned income means:

Earned Income Defined:Earned income is generated from employment or self-employment.

Earned income would not include income from:

• Social security
• Deferred compensation
• S corporation distributions

As long as you have earned income – you can contribute to a Roth IRA, regardless of your age.

If you are younger than age 18, an adult can open a custodial Roth IRA account for you (the adult will control the account until you turn 18 or 21, depending on the state you live in).

Second, let’s review what income phaseout ranges for a Roth IRA mean:

Income Phaseout Definition:Depending on the amount of money you earn each year, you may not be eligible to contribute the maximum or anything to a Roth IRA.

Note:If you earn over the maximum income limits and find that you can no longer contribute anything to a Roth IRA, then you can consider a back door Roth IRA contribution.

How much can I Contribute to my Roth IRA?

There are maximum annual contribution limits but no minimum contribution limits.

You do not need $1,000 to start investing in a Roth IRA.

You can start with an investment as small as $10.

The only caveat here is that some Roth IRA providers (like Vanguard, Fidelity, Charles Schwab, etc.) may not allow you to start investing with $10 – you may need to boost your investment up to $100 or more.

Acorns is the perfect investment app for the beginning investor. It takes all but 5 minutes to set-up and you have some pretty good quality investments.

Plus, you can invest as little as $5 with Acorns.

How to Open a Roth IRA

If you are ready to open a Roth IRA account, then it’s time to act.

Below are the 4 steps to open a Roth IRA account:

1. Select your Roth IRA company
2. Open your Roth IRA account
3. Fund your Roth IRA account
4. Select your investments

1. Select your Roth IRA Company

Before you even open your Roth IRA account, you have to select which company you want to hold your Roth IRA.

Below are my personal favorites:

1. Best Micro-Investing Roth IRA platform:Acorns
2. Best Automated & Hands-off Roth IRA platform:M1 Finance

There are many other great companies out there as well such as Vanguard (another personal favorite).

Acorns and M1 Finance in my opinion offer great services for low prices.

2. Open your Roth IRA Account

The next step is to actually open your Roth IRA account.

Here’s how long it should take you to open your Roth IRA account:

It really doesn’t take a long time to open your Roth IRA account… so you really can’t use the excuse “I don’t have time.”

Just saying 🙂

3. Fund your Roth IRA Account

Next, you have to fund your Roth IRA account.

How to fund your Roth IRA account:

• In your newly opened Roth IRA account, find the page (or link) to connect your bank account
• Update your bank routing number and account number
• Select how much (if any) you want to transfer from your bank to your Roth IRA
• Fund your Roth IRA with cash from your checking account (remember, up to a maximum of $6,000 if under 50 or $7,000 if 50 or over)

I would also call the Customer Service team to help you confirm this funding process and help you answer any questions you may have.

Remember that every Roth IRA platform is different, so I would always recommend for you to do your own research.

Note:This is the typical process to fund Roth IRAs. Depending on the company you select, you may have a slightly different approach. If you need help, reach out to the Customer Service support line.

4. Select your Investments

Lastly, you need to consider which investments you will buy in your Roth IRA.

A Roth IRA offers many different investment options, including:

• ETFs
• Stocks
• Bonds
• Index Funds
• Mutual Funds
• Real Estate Investment Trusts (REITs)

Investing in a Roth IRA is very similar to investing in any other, regular investment account.

You can:

• Invest automatically
• Buy and sell investments
• Monitor your investments

Roth IRA Advantages

The next step is understanding the key advantages of a Roth IRA.

These include the following:

• Flexible contributions
• Investment profits grow tax-free
• Extended Contribution Deadline
• No required withdrawals (RMDs)
• You can withdraw any contributions
• Good retirement planning tool for young folks
• Withdrawals are tax-free & penalty free if certain rules are followed

Roth IRA Advantage #1: Earnings and Investment Profits Grow Tax-Free

The number 1 reason why Roth IRAs are a preferred investment instrument is because the investment profits are not taxed.

In Roth IRAs, your investment profits are completely tax-free after age 59.5 and if you keep your account open for 5+ years.

You are not obligated to pay Uncle Sam a dime of taxes with a Roth IRA, assuming you follow the specified guidelines.

Roth IRA Advantage #2: Withdrawals are Tax-Free and Penalty-Free

This advantage is very similar to the one I just described above:

• Your investment growth is tax-free
• Anything you withdraw from your Roth IRA is tax and penalty-free*

*To be very clear – you do have to follow certain rules to make sure that everything really is tax and penalty-free.

The 2 general guidelines to avoid taxes and a 10% penalty on the investment profits are below:

• If you are 59.5 or older
• And opened your account 5+ years ago

Roth IRA Advantage #3: Can Withdraw Contributions Penalty and Tax-Free

There is a difference between the term investment gains and the term investment contribution.

Let’s take this sample scenario:

Even if you’re 22 years old and only had your Roth IRA for 2 years, you can still withdraw up to $1,000 without any penalties or taxes.

Why?

Because you’ve already been taxed on that $1,000 contribution.

In other words, Uncle Sam doesn’t care what you do with your original contribution – you can keep it in your Roth IRA or you can withdraw the money.

Note:You can withdraw your original contributions at any time and any age from your Roth IRA. I would advise against this, however, because withdrawing your money would ultimately defeat the purpose of saving for retirement.

Roth IRA Advantage #4: No Required Withdrawals (RMDs)

Traditional IRAs and 401k’s force you to take out a portion of your money at age 72.

For a Traditional IRA and 401k this means:

• You’ll have to pay income taxes on whatever you withdraw

Roth IRAs do not have this rule – they do not have RMDs (required minimum distributions).

Why do Roth IRAs not have RMDs?

That’s because you already paid taxes on your original contributions (remember the after-tax money/paycheck example).

Note:Since you already paid taxes on your original Roth IRA contribution, Uncle Sam won’t force you to pay your taxes 2x, so you won’t have required withdrawals.

Roth IRA Advantage #5: Roth IRAs are Typically a Good Retirement Planning Tool for Younger Folks

Roth IRAs typically are a great retirement planning tool for young folks.

That’s because if you’re young, you are typically at the beginning of your working career, earning the lowest wages in your life:

• You’re in one of the lowest tax brackets

If you’re in a low tax bracket, that means it probably doesn’t hurt you too much if you’re taxed on Roth IRA contributions today (instead of having those contributions being deducted from your income taxes, as with Traditional IRAs).

Down the road, let’s say when you are 40 or 60 years old, you are typically toward your peak earning years:

• You’re in a higher tax bracket

If you’re in a higher tax bracket, you’ll likely want to consider other options like a Traditional IRA, since contributions will be deducted immediately from your income tax returns, which means you’ll have a lower tax bill in the current year.

Note:Keep in mind that if you earn over the Roth IRA phaseout limit, then you won’t be eligible to contribute to a Roth IRA… not unless you do a backdoor Roth IRA.

Roth IRA Advantage #6: Extended Contribution Deadline

I had this experience the first year I opened my Roth IRA: It was the middle of December and I only had made $500 of Roth IRA contributions.

All of a sudden, I found myself scrambling to hit the December 31st contribution deadline… until I realized that the Roth IRA contribution deadline is extended (phew!).

This means that:

In plain English:

• Current date: February 2, 2021
• You’re looking to make a $6,000 Roth IRA contribution for 2020
• Roth IRA contribution deadline for 2020: April 15, 2021

Thank goodness for flexible deadlines!

Roth IRA Advantage #7: Flexible Contributions

Just as with flexible contribution deadlines, a Roth IRA also offers you flexibility in the type and amount of contributions you add to your Roth IRA.

You don’t have to:

• Make 1 lump-sum contribution of $6,000 each year
• Make $500 monthly contributions (for a $6,000 annual total)

Here’s what you can do:

• Invest when you want to invest
• Contribute when you have the money
• Automatically set up an investment strategy
• Dollar cost average $12 every 2 weeks (for example)
• Randomly pull money into your Roth IRA when you have money

Basically, you treat a Roth IRA just like any other investment account.

The tax treatment (after-tax) and contribution amount ($6,000 if you’re under 50) are the major differences.

Does a Roth IRA have an Early Withdrawal Penalty?

Yes, there is an early withdrawal penalty with a Roth IRA.

You may have to pay a 10% penalty in addition to paying income taxes if you withdraw any of the investment profits (not contributions) from your Roth IRA before age 59.5.

There are some ways to get around this early withdrawal penalty, which include:

Below are some additional scenarios that may help you understand what will happen with your Roth IRA withdrawal scenarios:

If you:

• Are younger than 59.5
• Had your Roth IRA for less than 5 years

You may be able to avoid:

• Penalties
• Not taxes

In [some of] the following situations:

• Pay for a disability or death
• Pay for qualified education expenses
• Pay for qualified birth or adoption expenses
• Pay for a first-time home (up to $10,000 in your life)
• Pay for unreimbursed medical expenses or health insurance if you’re unemployed

On the flip side, let’s check out what happens if you’ve had your Roth IRA for 5+ years.

If you:

• Are younger than 59.5
• Had your Roth IRA for 5+ years

You may be able to avoid:

• Penalties
• Taxes

In [some of] the following situations:

• Pay for a disability or death
• Pay for qualified education expenses
• Pay for qualified birth or adoption expenses
• Pay for a first-time home (up to $10,000 in your life)
• Pay for unreimbursed medical expenses or health insurance if you’re unemployed

When can you Withdraw from a Roth IRA?

To keep matters simple, 59.5 is the age at which you can withdraw from a Roth IRA without the 10% penalty and without income tax.

Note that you do need to have your Roth IRA open for 5 or more years to avoid both penalties and taxes.

Note:For simplification purposes: If you withdraw any of the investment profit (not your original contributions) before 59.5, then you will likely have to pay a 10% penalty and you’ll have to pay income taxes on the investment profit. In other words, the purpose of investing in a Roth IRA is completely defeated. Don’t withdraw money it if it can be avoided.

What is the Difference Between a Roth IRA and a Traditional IRA?

I’ve been asked this question multiple times.

Ultimately, both the Roth IRA and the Traditional IRA are excellent investment accounts.

Below is a chart that details which account might be the best for you, given your situation:

As you can see, choosing the optimal investment account really has to do with your income earning potential and how much you believe your earned income will be during retirement.

That’s why when you’re young (ie – you have a higher income earning potential, since you’re at the beginning of your career), it’s typically recommended that you choose the Roth IRA route.

Related: Roth IRA vs Traditional IRA

Note:For anyone who’s curious, I’m 100% invested in Roth IRAs and Roth 401k’s (which I can discuss later). I am all-in when it comes to establishing a Roth account.

Can you Lose Money in a Roth IRA?

Investing in a Roth IRA is like investing with any other account – so the potential to win or lose money is always a risk.

However, if you:

• Consistently invest
• Maintain a long term mindset
• Invest inlow-cost index funds
• Never withdraw your investments

Then chances are, after 4 or 5 decades, you would have made some serious [tax-free] profits.

Let’s check it out in the sample scenario, below.

Remember, over the past 50 years, the stock market returned an average of 7% which is why I used this 7% return number here.

Some years could be a higher return, others a lower return, but the average should be around 7%.

Roth IRA: The Bottom Line

A Roth IRA is a tax-advantaged retirement investment account.

• Investment gains and profits are tax-free
• Your contributions are after-tax (you don’t receive a deduction)
• Your withdrawals are tax-free (assuming you follow several Roth IRA rules)

Typically speaking, a Roth IRA is a retirement account that can help younger folks who expect to see an increase in their income during retirement.

When they start withdrawing money from their Roth IRA during retirement, they won’t have to pay taxes.

There are 2 requirements to contribute to a Roth IRA:

• You must have earned income
• Your annual income must fall within the phaseout ranges (explained above)

So when is a Roth IRA the best option for you?

• It all depends on how you envision your future income during retirement
• If you expect to be in a higher tax bracket in retirement then it would likely be better to invest in a Roth IRA today

Essentially, it’s sort of a gamble whether a Roth IRA is the best for you because it really comes down to your future.

However, I would argue that most of you know yourselves by now.

You know whether you want to:

• Grow your career
• Grow your income
• Earn a lot of money in your future years
• Marry (and have an additional income stream on tax returns)

If you said “yes” to any of the above options, then a Roth IRA may likely be the best option for you because chances are you’ll end up in a high tax bracket during retirement.

Here’s what I do:

I’ve been investing in a Roth IRA since I was 20 years old.

I firmly believe that a Roth IRA is the right choice for me, because I know that when I’m ready to retire at 65 or 70 (yes, I love to work), I better be in a higher tax bracket than I am today.

In the end, it’s a personal preference.

But, it’s a good idea to start thinking about your options today.

Your bank accounts will thank me later!

Do you plan to invest in a Roth IRA? Comment below and let me know your thoughts.