The Individual Retirement Account (IRA) is one of the most popular tools used by Americans to save for retirement. Traditional IRA contributions may be tax-deductible, which will lower your current taxes while also helping you plan for a financially secure retirement.
One of the biggest drawbacks to traditional IRAs is that contributions are made pre-tax, so you’ll have to pay income tax on funds when you make withdrawals during retirement. But there is a way to enjoy tax-free IRA withdrawals in retirement: by contributing to a Roth IRA.
Roth IRAs are funded with after-tax dollars, so you don’t have to pay income tax on funds you withdraw during retirement. The trade-off is that you won’t receive a current tax deduction for Roth IRA contributions like you could with a traditional IRA.
In this article, we explain step by step how to open a Roth IRA.
Decide If a Roth IRA Is Right for You
The first step is to decide if a Roth IRA is right for you. Start by answering a few questions, beginning with: Which is more important to you — a current tax deduction or tax-free income in retirement? Or in other words, do you want to receive a tax break now… or later?
Many people want to do everything they can to lower their current income taxes. For them, a traditional IRA is probably the right choice since it may allow a current tax deduction. Others want to realize as much income as possible when they start tapping their retirement accounts to help them live the retirement lifestyle they desire. For them, a Roth IRA is probably the right choice since it allows tax-free withdrawals in retirement, thus helping stretch retirement savings out further.
In addition, Roth IRAs allow tax-free withdrawals of contributions (but not earnings) before age 59½ for any reason without paying a 10% early withdrawal penalty like with a traditional IRA. So you have more flexibility with a Roth IRA. For example, some families use Roth IRAs to help save money for college. And there are no required minimum distributions (or RMDs) with Roth IRAs like there are with traditional IRAs, which provides even more flexibility.
Determine If Are You Eligible to Open a Roth IRA
The next question is an important one because not everyone is permitted to open and contribute to a Roth IRA. Eligibility phases out above certain modified adjusted gross income (MAGI) limits:
If you’re single and your MAGI this year is less than $125,000, or if you’re married and file jointly and your MAGI this year is less than $198,000, you can open a Roth IRA and make a full contribution.
If you’re single and your MAGI this year is between $125,000 and $140,000, or if you’re married and file jointly and your MAGI this year is between $198,000 and $208,000, you can open a Roth IRA and make a partial contribution.
If you’re single and your MAGI this year is $140,000 or higher, or if you’re married and file jointly and your MAGI this year is $208,000 or higher, you can’t open or contribute to a Roth IRA.
A Roth IRA conversion is a tool that allows individuals to convert money from a tax-deferred retirement account like a traditional IRA or 401k into a Roth IRA.
Learn More: Roth IRA Conversion Calculator
The annual contribution limit for Roth IRAs in 2021 is $6,000, or $7,000 if you’re age 50 or over. This limit applies to Roth and traditional IRAs combined. For example, you could contribute $3,500 to a traditional IRA and $3,500 to a Roth IRA this year if you’re 50 years old.
Both you and your spouse can each establish separate Roth IRAs and contribute up to these amounts. As a result, you and your spouse could sock away up to $12,000 for retirement this year in Roth IRAs, or $14,000 if you’re age 50 or over.
Choose a Roth IRA Provider
There is a wide range of options for opening your Roth IRA. If you are more of a do-it-yourself type of investor, you might opt for an online brokerage where you can choose your investments yourself. If you’d rather get some help and investment advice, you might opt for an investment advisor or robo-advisor.
The latter is an online service that chooses investments for you in order to build a diversified Roth IRA portfolio. Robo-advisor fees are typically lower than the fees charged by investment advisors, but their services also tend to be more limited.
Most online brokerages offer a comprehensive selection of investment options including index mutual funds and exchange-traded funds (ETFs), along with retirement planning tools and some level of customer support. Investment advisors usually offer more hands-on support and advice as well as other services such as tax and trust and estate planning. Robo-advisors typically create a handful of portfolios based on investors’ risk profiles — more aggressive portfolios for investors with a higher risk tolerance and less-aggressive portfolios for investors with a lower risk tolerance.
Make Your Investment Choices
The next step for do-it-yourself investors is to select your investments. Your goal should be to create a well-diversified Roth IRA portfolio that fits within your time horizon and risk profile.
For example, if you are relatively young with several decades until you plan to retire and have a high risk tolerance, you might choose riskier, more aggressive investments like technology and emerging market stock funds. These funds usually offer higher potential returns in exchange for higher risk, but your long-term time horizon helps minimize the impact of short-term volatility.
Conversely, if you are closer to your retirement date and have a low risk tolerance, you might choose safer, less aggressive investments like bonds and cash equivalents. These offer lower potential returns but also less investment risk, which might be important if you have to start withdrawing money from your Roth IRA to meet your retirement living expenses in the near future.
Another option is to select a target date or lifecycle fund. These funds contain a mix of investments (or asset allocation) that is appropriate for investors based on their age. Over time, the asset allocation is shifted to reflect the fact that you’re getting closer to retirement.
If you decide to work with a financial advisor or robo-advisor, you will tell your advisor your time horizon and risk tolerance, and the advisor will choose investments based on these criteria.
Set Up Automatic Contributions
The best way to build up your Roth IRA over time is to make contributions automatic by setting up electronic funds transfers from your checking or savings account to your Roth IRA on a regular basis. For example, these transfers can be made on a monthly or bi-weekly basis, or according to when you get paid. Doing so follows the mantra of “paying yourself first.”
Let’s say you’re 40 years old and want to contribute the maximum amount to your Roth IRA, or $6,000 this year. You could arrange for $500 to be transferred from your checking account to your Roth IRA each month, which would result in a total annual contribution of $6,000 after 12 months.
Based on your particular circumstances, a Roth IRA might be the right retirement savings account for you. Following these steps to opening a Roth IRA could help put you on the road to a financially secure retirement.
Personal Capital can help you save for retirement. For free, you can try out the Personal Capital Retirement Planner, an interactive online tool that allows you to forecast your chances of retirement success. With the Retirement Planner you can:
Run different scenarios in a side-by-side comparison
Review the impact of large expenses on your retirement
Add sources of income to your overall plan
See how your retirement plan would have fared in historic crashes
Get a spending plan for retirement
Investors with $100,000 or more of investable assets are eligible for opening a Roth IRA with Personal Capital. As a client, you get access to a team of licensed fiduciary advisors, tax optimization, and ongoing rebalancing.
Get Started With Personal Capital
Personal Capital compensates Don Sadler (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.