Content of the material
- What is compound interest?
- How to Open a Roth IRA
- Roth IRA taxes vs traditional IRA taxes?
- No Required Minimum Distributions (RMDs) for Roth IRAs
- How to Start a Roth IRA
- 2. Choose where you want to invest
- How Do I Maintain My Roth IRA?
- How do you get the most out of your Roth IRA?
- Know what you want to invest in
- Choose your Roth IRA custodian carefully
- Contribute money regularly
- Stay mindful of your tax bracket
- A Roth Growth Example
- How often does a Roth IRA compound interest?
- Can I Set Up a Roth IRA for My Spouse Who Doesnt Work?
- How does a Roth IRA grow?
- 1. An individual makes routine contributions
- 2. Interest and dividends accumulate
- 3. Interest compounds over time
- Roth IRA vs. traditional IRA
- We put your best interest first
- Withdrawals: Qualified Distributions
- Subscribe to our Retirement Roadmap newsletter
- Schwab Brokerage
- Schwab Password Reset
- Schwab Bank
- Schwab Intelligent Portfolios®
- Schwab Trading Services
- Workplace Retirement Plans
What is compound interest?
Compound interest means that when interest is earned on your money, it is reinvested into the account. Doing so means that it earns even more interest. This cycle allows modest contributions to grow exponentially over time.
How to Open a Roth IRA
Opening a Roth IRA doesn’t take a bunch of time or paperwork. It’s just as simple as opening a checking account or contacting a financial advisor. Many banks offer Roth IRAs through an online application. You could also open a brokerage account with an investment firm (online or in person). A brokerage account is an investment account you can open directly through a bank or brokerage firm that lets you buy and sell all kinds of different investments.
Here are the seven steps to open a Roth IRA.
Roth IRA taxes vs traditional IRA taxes?
With a Roth IRA, you pay taxes on your contributions upfront so you don't have to pay them later when you withdraw money from your retirement fund (as long as your account has been open for at least five years).
This is the biggest difference from a traditional IRA, which lets you delay paying taxes until you withdraw funds later down the road. With traditional IRAs, your contributions are also tax-deductible, up to certain limits, so your contribution reduces the amount you owe in taxes each year.
A good rule of thumb when choosing between the two types of IRA accounts is to consider your tax bracket:
- Choose a Roth IRA if you expect that you'll be making more money in your later years — and thus in a higher tax bracket. It makes more sense to pay taxes today to take advantage of your current low tax rate before it goes up. Plus, since your withdrawals from Roth IRAs don't count as income and aren't taxed after 59 and a half, you can count on every dollar in your account when making withdrawals.
- Choose a traditional IRA if you expect that you'll be making less money in your later years — and thus in a lower tax bracket. In this case, it makes more sense to reduce your taxable income in the present, so in theory you'll pay less in taxes both now and in the future when your tax rate is lower.
Use an online calculator like this one from Charles Schwab to help you decide between a Roth IRA or a traditional IRA.
No Required Minimum Distributions (RMDs) for Roth IRAs
With traditional IRAs, you have to start taking required minimum distributions (RMDs) when you reach age 72, even if you don’t need the money. That’s not the case with a Roth IRA. You can leave your savings in your account for as long as you live, and you can keep contributing to it indefinitely, as long as you have qualifying earned income and your modified adjusted gross income (MAGI) doesn’t exceed the annual limit for making contributions.
These features make Roth IRAs excellent vehicles for transferring wealth. When your beneficiary inherits your Roth IRA, generally, they will have to take distributions that could be stretched out over 10 years. This can provide years of tax-free growth and income for your loved ones.
How to Start a Roth IRA
You can open a Roth IRA at a bank, credit union, brokerage or mutual fund company. Follow these steps:
- Decide whether you want a deposit account or an investment account for your Roth IRA. An investment account offers greater potential for growth, but comes with risks. Your account balance can go up and down. The balance in a deposit account won’t decrease (unless you make withdrawals), and it’s federally insured for up to $250,000, but you may not earn as much.
- Make a contribution. You can put up to $5,500 a year into your Roth IRA. If you’re age 50 or older, you can make an additional $1,000 catch-up contribution each year.
- Monitor your account. Over time, tax-free compounding interest or investment returns help your balance grow.
- Make plans to live the life you want when you retire. Planning ahead by opening a Roth IRA and contributing to it every year can help you achieve your retirement dreams.
2. Choose where you want to invest
While you have quite a few options for how to set up your Roth IRA, the route you choose depends on how comfortable you are doing things on your own. If DIY is in your DNA, then go online and set up a Roth IRA.
But odds are, you probably have questions an online chatbot can’t answer. If you feel more comfortable working with someone face-to-face, reach out to a SmartVestor Pro. They’re RamseyTrusted investing professionals who can guide you through all your retirement options, including setting up a Roth IRA.
How Do I Maintain My Roth IRA?
Once you choose the mutual funds for your Roth IRA, it’s important to stick with them for the long haul. Don’t panic when the market ebbs and flows. The value of your Roth IRA will rise and fall with the stock market, but over its lifetime, you should see a steady growth trend. Just continue making regular contributions and stick with it despite possible market changes.
Over 30 years, if you invest the annual max of $6,000 into a Roth IRA, it could grow to $1.4 million. (Historically, the 30-year return of the S&P 500 has been roughly 10–12%.10) The best part is, your contributions would only total $180,000, and the rest—$1.2 million—would be tax-free growth.
Those numbers can change depending on how much you invest, how long you have until retirement, and what you expect your annual return to be. You can use our investment calculatorto customize those details for your own financial situation.
How do you get the most out of your Roth IRA?
Follow the steps below if you hope to get the most value out of your Roth IRA.
- Know what you want to invest in.
- Choose your Roth IRA custodian carefully.
- Contribute money regularly.
- Stay mindful of your tax bracket.
Know what you want to invest in
What you invest in is largely up to you, but you need to consider your investing experience and your risk tolerance. Some types of investments are well-suited to beginners, while others are difficult to turn a profit unless you have specialized knowledge of the industry.
Some investments are also riskier than others. Usually, you can afford to invest heavily in riskier assets, like stocks, while you’re younger because your portfolio will have decades to recover from a loss before you need to draw upon it. But as you age, your risk tolerance declines, and then you’ll want to move more of your money into less volatile assets, like bonds.
You also have to make sure you’re diversified between many investments and sectors. This reduces the risk of serious loss if one of your investments starts performing poorly. Mutual funds, including low-cost index funds, provide a simple way to diversify your investments quickly.
Choose your Roth IRA custodian carefully
Once you have some idea of what you want to invest in, you need to look for a Roth IRA custodian that offers these options. If you think you may want to open other types of investment accounts, like a traditional IRA, a taxable brokerage account, or a 529 college savings account, in the future, look for a custodian that offers these as well.
Pay attention to fees associated with your account as these can eat into your profits over time. Your custodian should provide a list of fees, or you can reach out to the company and ask questions about the costs.
Contribute money regularly
You technically have up until the tax deadline for the year — usually April 15 of the next year — to contribute to your IRA, but waiting this long deprives you of months of potential investment growth. You’re better off making a lump-sum contribution at the beginning of the year or contributing a regular amount each month.
Stay mindful of your tax bracket
Because Roth IRA contributions don’t reduce your taxable income for the year, you could end up in a higher tax bracket than you’re used to if you’ve contributed to a tax-deferred account in years past. In that case, you may want to put a little money in a tax-deferred account to keep yourself in a lower tax bracket so you can pay a smaller percentage in taxes on your Roth savings.
If you’re earning less this year than normal, consider converting some of your tax-deferred retirement savings to Roth savings. You will pay taxes in the year you do the conversion, but this may not affect your tax bracket if you’re careful about how much you convert at a time.
Roth IRAs give you a lot of freedom to invest in a way that aligns with you preferences. But if you want to get the most out of yours, it helps to understand how they work and what steps you can take to maximize your savings. Review your Roth IRA contributions and asset allocation at least once a year and make any changes you feel are necessary to keep yourself on track for the retirement you want.
A Roth Growth Example
How much can Roth IRA compound interest add to your account balance over time? Say that you open a Roth IRA and deposit $6,000 initially, at age 25. Then, you deposit another $500 per month, and earn the same 7% annual rate of return, for the next 40 years. Every year, you’re contributing $6,000 in total, the Roth contribution limit until age 50. At age 65, you'd be a millionaire. You would have contributed just $246,000 in total, but thanks to compounding, you would $1,287,657.42 saved for retirement.
But all of the profits earned would be tax-free if you're not touching it until you retire (or reach age 59 ½). That could significantly reduce your tax bill if you anticipate being in a higher tax bracket in retirement. Any Roth IRA funds not used during your lifetime could be passed on to a beneficiary.
One way to automatically reinvest dividends is by setting up a dividend reinvestment plan, or DRIP.
How often does a Roth IRA compound interest?
Generally, when discussing how often Roth IRA interest compounds, you're talking about the annual rate of return. This represents the average returns (including price growth, dividends, and interest) earned by the different investments in your account for the year.
Can I Set Up a Roth IRA for My Spouse Who Doesnt Work?
Yes. If you file a joint income tax return and at least one of you has a taxable income, you can both contribute to your own separate Roth IRAs. But the IRS income-eligibility limits still apply.
Let’s say 40-year-old John makes $150,000 and his wife, Kate, stays home with their kids. John can put up to $6,000 in his IRA. Kate can open a spousal IRA in her name and contribute the maximum amount of $6,000 as well.
How does a Roth IRA grow?
While the return each individual receives on their Roth IRA depends on the investments they make throughout their career, there are some key concepts that make this type of retirement account increase over time. Here's a basic overview of how a Roth IRA grows:
1. An individual makes routine contributions
While you can make a contribution through a Roth IRA program provided by your employer, you can also open up your own Roth IRA account. This makes Roth IRAs accessible to everyone, including freelancers. Each Roth IRA contains a portfolio of investments. Typically, when you establish a Roth IRA, you work with a financial institution that helps you choose investments for your portfolio based on your financial goals and what level of risk you select.
When you open your Roth IRA account, you can select how much of your income you want to invest. You may decide to contribute a percentage of your annual income or a percentage of each paycheck if you want to break your yearly contribution into smaller investments.
Related: How To Start a Portfolio
2. Interest and dividends accumulate
How much each person's Roth IRA earns in a given period of time depends on what types of investments it includes. As your investments increase in value, you earn interest and dividends, which get added to your account balance. While it's impossible to predict how much your investments may generate in dividends and interest each year, having a well-rounded portfolio that includes a combination of stocks, bonds, mutual funds, exchange-traded funds (ETFs), certificates of deposit (CDs) and money market accounts can improve your outcome.
3. Interest compounds over time
While making regular contributions to your Roth IRA certainly helps, the real power of this type of retirement account comes from compounding interest. In addition to earning dividends and interest from your investments, a Roth IRA allows you to earn returns on your account balance as it grows. On average, Roth IRA accounts provide 7% to 10% in annual returns. This allows your account balance to increase even during years when you don't make financial contributions to your Roth IRA.
Roth IRA vs. traditional IRA
The main difference between a Roth IRA and a traditional IRA is how the government taxes contributions. When you make a contribution to a traditional IRA, you set aside pre-taxed dollars. In other words, you don't pay taxes on this income because you're saving it for retirement. However, when you withdraw your funds in the future, the government can tax you at a higher tax bracket, depending on your income and the amount of funds you access. A Roth IRA takes the opposite approach. The government taxes your Roth IRA contributions before you deposit them into your account.
This means when you withdraw your funds in the future, you don't have to pay taxes on them again. While both strategies have their advantages, assessing your current income level, retirement savings strategy and anticipated tax rate at the time of retirement can help you determine whether a Roth IRA or a traditional IRA is the better choice for you. Here are some of the key differences to consider when comparing a Roth IRA with a traditional IRA:
A Roth IRA can help individuals save money on taxes if they expect to be in a higher tax bracket when they retire, whereas a traditional IRA may make sense for people who expect to be in a lower tax bracket.
Entry-level professionals and younger people tend to benefit from making contributions to a Roth IRA, while more established professionals often benefit from making contributions to a traditional IRA.
While beneficiaries of traditional IRAs pay taxes on distributions, Roth IRAs allow you to lock in the current tax rate for beneficiaries to decrease expenses.
Individuals with traditional IRAs must take out required minimum distributions when they turn 72, whereas individuals with Roth IRAs can leave their savings in their account indefinitely.
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Withdrawals: Qualified Distributions
A Roth IRA is a tool designed to help you save for retirement. Because of that, there are restrictions around when you can take qualified distributions (meaning tax-free and penalty-free withdrawals).
In general, you may only take qualified distributions from your Roth IRA once you’ve had the account for at least five years and you reach age 59½. That being said, there are plenty of exceptions to this rule. For example, you may take qualified distributions if you are disabled. And when you die, a distribution can be made to your beneficiary or your estate.
Other situations where you may withdraw money from your Roth IRA after five years without paying taxes or a penalty include:
- To buy, build, or rebuild your first home
- To pay for unreimbursed medical expenses that are more than 7.5% of your adjusted gross income
- To pay for medical insurance premiums while unemployed
- To pay for qualified higher education expenses
Finally, Roth IRAs are unique because you’ve already paid taxes on your contributions. As a result, the IRA allows you to withdraw your contributions — but not your earnings — at any time. For these reasons, some financial planners say that Roth IRAs make great backup emergency savings accounts.
Of course, just because the IRS allows you to withdraw your contributions doesn’t necessarily mean it’s a good idea. The money you put into the account is meant to prepare you for retirement. When you withdraw your contributions, that money is no longer growing and compounding. So for each dollar you withdraw, you’re reducing the amount you’ll have available during retirement by many times more. The name of the game in investing is long-term — keep your money in as long as possible so compound interest can work its magic.
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