Why, Where & How of Roth IRAs

Someone contact me recently about how to set up a Roth IRA. It’s a common enough question that it feels like a good time to revisit this topic. In this article I’m going to tell you exactly why, where and how to set up a Roth IRA and even make three investment suggestions for three generic situations. Your specific situation could differ, of course.

But first, what? A Roth IRA is a little bit like a trust fund on the cheap. It’s held by a custodian who does a few duties surrounding it. It’s a way of holding an account, sort of like how you could have a passbook savings or a joint checking or a workplace retirement plan: they’re all structured slightly differently. This has nothing to do with how they’re actually invested, and very little to do with where you went to open it. They are very similar to Traditional IRAs, but differ in two important ways: you do NOT get a tax deduction for putting money in, but you DO get to withdraw your contributions – and often your earnings – tax-free. That means that it’s feasible to get your money back out if you need it for an emergency (or because you’ve reached your goal.)

Why? Several reasons make them a great entry-level financial tool. It has some special tax treatment that works particularly well for people early in their careers. The tax deal is that you don’t have to pay taxes on the earnings EVER if you hold it for at least 5 years and have reached 59 ½ years old. In practice, this means that you can score big if you put money in a Roth early in your career, particularly when you’re in a low tax bracket and don’t need a tax deduction (much) anyway, let it grow. Tax-free growth that comes out tax-free at the end is a lovely gift to give yourself. (Other people benefit from Roths, not just the young, but the case gets muddier after that.)

Even if you’re not saving for old age, it’s also a good way to hold your emergency money. If no emergency comes up, you will eventually use it in retirement, right? In the mean-time, it looks like a retirement account to creditors so you can’t (usually) lose it in a lawsuit.

Also, because it’s categorized as a retirement account, it doesn’t get used against you in calculating your expected family contribution when applying for financial aid. This makes it the best way to save for college, too!

Where? Here’s where I’m going to give you a fork in the road for three different specific investments. I am writing this for general information on my blog. I do not know who is reading this. I do not know how much savings you have. I do not know your risk tolerance or ability to not get taken by sharks. These next three paragraphs are READ AT YOUR OWN RISK, okay?

Is this for your emergency money? (I mean your DEEP emergency money that you wouldn’t touch until you’d lost your job and used up your rainy day money, not the savings for intermittent things like needing new brakes.) If you don’t expect to touch it then you want it to be in CDs, perhaps several with different time periods.

Do you already have your three to six month’s living expenses tucked away and this is for a middle-term goal? I’m talking more than four years, and the plans are not firm. Saving for college, saving for a house *someday*, saving to buy out your boss *someday*? Then I’d probably put you in a single balanced mutual fund like this one for people who are just getting started on investing.

On the other hand, are you swinging for the fences, looking to save for retirement, not particularly intending to do anything else with it for the next ten years? Then get into a total stock market index fund like this one is a great place to see your money grow OVER time (but definitely not ALL the time.)

How? You open up an account at a Custodian. A Custodian is the place that is responsible for three things: making sure your money doesn’t get stolen, doing some basic record keeping and reporting (to both you and the government), and putting some very basic rules around what you may and may not invest in. You may not invest in your brother-in-law’s vacation home. You may not invest in the oil well your neighbor is trying to dig. The rules aren’t too stringent around this: they’re just there for your protection as well as to make sure this is really a savings plan versus a way to fund your current lifestyle.

You can have multiple Roth IRAs, so go ahead and open another one for separate purposes. For your emergency money, you can open those at your own bank, or use an online bank. I use this one. For investing, I suggest a retail brokerage account like this one.

For most people making over $10,000 and under $110,000 it’s basically as easy as sending the custodian money and telling them what year it’s for. The hard part is there are large swathes of people who are not ALLOWED to make a Roth contribution at all. Here are the rules.

  • The most you may put in for any specific calendar year changes, but for 2018 it was $5,500 if you’re under 50 and $6,500 if you’re 50 or over, per person.
  • You have until April 15th of 2019 to make a Roth Contribution for the 2018 tax year. You have that amount of time because it’s typically a good idea to do your tax return (or at least rough it in) before you make a Roth contribution assigned to that tax year because of the next two rules:
  • You cannot contribute to a Roth if you (or your spouse) do not have earned income. To contribute $5000 each there must be at least $10,000 in earned income (which mostly means from jobs or the taxable part of self-employment.)
  • You cannot contribute to a Roth if you earn too much money. That means a single person with over $120,000 or a married couple with over $189,000 in income (from all sources) would not be allowed to make a contribution for a Roth for that year.

That’s enough for now. There are special rules about rollovers and conversions, recharacterizations, “back-door Roths” and various distribution strategies that make this a worthwhile reason to hire a financial planner, but to get you started, this should do it. Good luck!