How does a roth ira work reddit

In plain English, an IRA is an account you put money into that receives favorable tax treatment. Each year you can elect to contribute money to your IRA using "out of pocket" money, as opposed to your 401(k) contributions which must be funded through payroll deductions. The annual contribution limit is $6,000 in 2021 (plus an additional $1,000 for people who are 50 years or older), but be aware that if your income is high, you may not be allowed to contribute that much or anything at all (the IRS has an overview page on IRA contribution limits). Do not go over this limit or penalties will be applied (and no, you can't get around it - your IRA provider reports your contributions to the IRS).

In most cases, you must open your own IRA. The "individual" in "IRA" truly means individual!

IRA plans come in several flavors, but the two main ones are:

• Traditional IRAs, which reduce your taxable income if you are under a certain income limit. Since you contribute to an IRA with money that has been taxed already, you claim a deduction at the end of the year if you qualify. After you get your refund for your traditional IRA contribution this money becomes "tax-deferred" - you will pay income tax on your contributions and your earnings at your marginal tax rate when you take distributions from your traditional IRA in the future.

• If you contribute to a Roth IRA, your contributions have already been taxed at your current marginal income tax rate. In exchange, earnings may be distributed tax free if the distribution meets certain age and eligibility requirements.

Which one do you choose? It depends on a lot of factors, but the big ones are:

• Income - Qualifying high earners are usually better off contributing to a traditional IRA, as this allows them to avoid paying their current high marginal tax rate. Conversely, those with lower incomes usually favor the Roth IRA, as they can pay a low marginal tax rate now in exchange for never being taxed on that money again.

• Your guess about your future income tax rates - Those that believe they will be in a lower income tax bracket when they retire usually favor the traditional IRA if they qualify for the deduction. Those that believe they will be in a higher income tax bracket when they retire usually favor the Roth IRA. Those that believe income tax rates will rise across the board in the future usually favor Roth IRAs.

Money you contribute to your IRA must then be invested in the funds your IRA provider offers you.

ELI5: How should I invest within my IRA?

Once you have contributed to your IRA, you are still left with the somewhat daunting decision of how to invest within your plan. One of the primary advantages of an IRA is that you get to choose who holds it - if you choose a provider like Vanguard, Fidelity, or Charles Schwab, you'll have access to lots of inexpensive index funds or ETFs that you can invest in without paying a commission.

If you're just getting started, these are good options for an IRA:

Those are all intended to be easy options if you are just getting started and still learning about investing. They include US stocks, international stocks, and bonds. By investing in this manner you are instantly diversified across thousands of different securities, will never significantly underperform the market, and are mathematically certain to outperform most investors purchasing more expensive funds.

If you have more than about $50,000 invested, especially in multiple investment accounts, please keep reading!

Once you've been investing into retirement accounts for a few years and have more money to allocate and a bit more experience with investing, a good strategy is the three-fund portfolio. With a three-fund portfolio, rather than relying on a target date fund to manage your allocation, you manage your own allocation of broad index funds in the three major asset classes: US stocks, international stocks, and bonds. Read more about setting up a three-fund portfolio in the investing wiki page.

Note: If you have other retirement accounts, your asset allocation needs to be considered across all of your accounts. Read the Bogleheads' Wiki page asset allocation in multiple accounts for more on this topic.

Your asset allocation is how you divide your money amongst the various asset classes and the various funds you've elected to invest in. Here are some basic rules of thumb:

• The core of your portfolio should be the three major asset classes: US stock market index funds, international stock market index funds, and bond index funds.

• A good starting point for determining your bond holding percentage is [your age]%. Subtract 10% or 20% from your age if you want to be more aggressive, but don't go below 10% regardless of your age.

• 30% to 40% of your stock holdings should be international (20% at the very least) (source).

• The younger you are, the more risk you can afford to take on in the form of higher allocations to stocks.

• Your asset allocation can and should change over time. A 25-year old's investments will be very different than a 55-year old's.

• Target date funds take the work out of asset allocation for you. Target date funds will automatically get more conservative as you age, reducing your exposure to major market movements as your ability to wait them out declines. If you are fully invested in a target date fund in your 401(k), it's probably a good idea to go with a target date fund in your IRA as well.

Some other frequently asked questions

1. The contribution limit for an IRA is $6,000 - can I contribute $6,000 to both a Roth IRA and a traditional IRA?

No. The $6,000 contribution limit is a total limit to all IRAs you contribute to in a given tax year. As an example, someone with two IRAs could contribute $6,000 to IRA A and the remainder to IRA B (or any combination that adds up to $6,000). That said, there's no limit on the number of IRAs you can have.

2. I do not report any earned income to the IRS because of the overseas earned income exclusion, my "income" is a tax-free scholarship, etc. Can I still contribute to an IRA?

No. You are allowed to contribute the lesser of your earned income or $6,000. If you do not report earned income, you are not eligible to contribute to an IRA.

3. I want to retire early. Should I contribute to my IRA and lock up my money until age 59½?

There are many ways to get money out of tax-advantaged accounts for early retirement. There are multiple approaches including:

• Using Section 72(t) distributions to take distributions received in substantially equal periodic payments (SEPP) — This can work well if you're retiring in your mid-to-late 50s.
• Setting up a Roth IRA ladder — This can work well if you can fund the first five years of your retirement from taxable accounts, pre-existing Roth IRA accounts, and perhaps part-time work.
• Read the post linked above for additional methods.

4. Should I pay off debt or contribute to my IRA?

IRA contributions rank behind emergency funds, employer-matched 401(k) contributions, and high-interest debt. You should only consider an IRA if you've taken care of these things first. Remember that paying down debt offers something that only scammers can claim otherwise - guaranteed, risk free return!

5. I'm a young person and want to invest aggressively - why invest in bonds at all?

Bonds provide a source of funds to purchase potentially higher-yielding investments when they can be had at discount prices during market downturns, reduce your portfolio's volatility, and usually offer a steady return themselves. On the technical side, there are numerous studies that show that 100% (or more) stock investors are not compensated in proportion to the extra risk they take on by doing so. While stocks have outperformed bonds over the long run to date, "past performance is not indicative of future returns." Finally, the psychological/emotional effects of a severe bear market really cannot be appreciated until they're felt first hand. It is one thing to say you're OK watching half of your investment portfolio evaporate in a few weeks. It's quite another to watch it happen for real and have the wherewithal to stay the course. Bonds offer some consolation in such a scenario.

6. Can I take out a loan against my IRA?

No. While some 401(k) plans offer options for loans, you cannot take out a loan against the principal of your IRA. For Roth IRAs you can withdraw your contributions tax- and penalty-free at any time. Once you do so you will not be able to replace previous years' contributions. For example, if you withdrew $50,000 of contributions from your Roth IRA you would only be able to replace up to the current annual limit of $6,000.

7. How do I open an IRA? Where should I open one?

Opening an IRA is generally very simple, requiring your tax identification information, personal identity information, and your bank account information for the electronic transfer of your initial contribution. You should open an IRA with a company known for providing low expense ratio index funds such as Vanguard, Fidelity, or Charles Schwab.

8. When can I contribute to an IRA?

You have until the tax deadline of the following year to make a contribution for a given tax year. For example, you had until April 18, 2018 to make an IRA contribution for tax year 2017.

9. My income is too high to contribute to a Roth IRA, and I also am ineligible for the deduction to a traditional IRA. What should I do?

The backdoor Roth IRA may be a good option for you. In this arrangement you contribute to a traditional IRA without claiming the deduction, then convert the balance to a Roth IRA soon afterwards. Here are some additional resources:

Notes: It is almost never a good idea to make a non-deductible contribution to a traditional IRA without then doing a Roth conversion, as doing so would mean that your earnings would be taxed. If you have any Traditional IRAs, the backdoor Roth IRA is likely not a good option due to pro rata taxes. This is discussed more in the resource links.

10. Is the backdoor Roth legal? It sounds sketchy.

There are no income limits on IRA conversions, so unless/until Congress changes the tax code the backdoor Roth is perfectly legal.

11. Do rollovers into my IRA count against my annual contribution limit?

No. Rollovers do not count against annual contribution limit for your IRA. For more information on rollovers, see the FAQ page on Rollovers.

12. Can I contribute the maximum allowed to both my 401(k) and my IRA?

Yes, as long as your income was high enough. The 401(k) and IRA contribution limits are separate and do not affect each other.

13. Can I take money out of my Roth IRA without penalty?

You can take out your Roth IRA contributions without penalty whenever you want. Taxes and penalties may apply if you want to take out earnings. You should also be aware that your investment company may have a minimum balance. However, since you cannot put past year's contributions back in your Roth IRA unless you return the money within 30 days, strongly consider avoiding such a withdrawal.

How does a Roth IRA work for dummies?

What is the downside of a Roth IRA?

Do Roth IRAs grow your money?

Can you become a millionaire with a Roth IRA?