Roth IRA 101: A Complete Guide to Investing for Beginners

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Looking for the perfect Roth IRA 101 guide to help you get started saving for retirement? In this post, we’re talking all about Roth IRA rules, requirements, and benefits.

I’ll also explain how to open one step-by-step and pick investments!

A Roth IRA is an incredible tax-advantaged retirement account that everyone should have in their portfolio, especially if you’re young and just getting started.

Believe it or not, but you don’t need an employer plan, hours of research, or thousands of dollars before starting a retirement plan.

There is so much information out there about investing that it can be extremely difficult to know who to listen to.

Before listening to any analyst, investment professional, or someone on YouTube, it’s important to understand the fundamentals of investing.

Rule number 1 of investing: NEVER invest in anything you don’t understand!

This post is your in-depth Roth IRA 101 guide that walks you through what a Roth IRA is, why they are so great, and the exact process to open one and choose investments.

Roth IRA 101: The Basics

First things first, let’s cover the basics. IRA stands for “individual retirement account” and “Roth” means that you contribute to it with money you’ve already paid taxes on.

A Roth IRA is NOT tied to an employer (like your 401k or 403b). That means you can open one regardless of your employer retirement plan!

I still recommend opening a Roth IRA even if you have a 401k at work. You’ll have more control over the investments in it, you don’t have to worry about rolling it over when you leave your job, and you might not always be eligible for a direct Roth IRA. So it’s good to get those contributions in now, while you’re eligible.

A Roth IRA (or any type of retirement account) is not an investment itself, it is an account that holds investments.

Think of a basket of eggs. Your Roth IRA account is the basket, and the eggs are your investments.

You have control over the quantity and types of eggs you keep in your basket. You can also remove eggs, add eggs, or switch them out at any time.

This post may contain affiliate links, which means I get a small commission should you choose to purchase or sign up through one of my links, at no extra cost to you. I only recommend products that I personally use and believe in. You can read more about this in my disclaimer.

Roth IRA Rules (Updated for 2022)

Here are the basic rules and eligibility requirements of opening and contributing to a Roth IRA:

$6000 per year contribution limit (the limit is $7000 if you are over 50 years old)
You must contribute earned income
Make less than $129,000 per year as a single person to contribute the full amount directly (the income limit for married filing jointly is $204,000)
You contribute with after-tax dollars (aka, you cannot write off your Roth IRA contributions on your tax return)
Earnings grow tax-free
You can withdraw your contributions at any time for any reason with no penalty once you’ve held the account for 5 years
You can begin withdrawing your contributions + earnings at age 59 and a half with no penalties

As you can see, there are a few eligibility requirements and rules of opening a Roth IRA. For the most part, as long as you earn less than $144,000 in modified adjusted gross income per year, you are eligible for a direct Roth IRA!

If you make more than the income limit, you can do a backdoor Roth IRA. I won’t go into too much detail here, but essentially you can contribute to a traditional IRA, pay taxes, and convert it to a Roth.

Your earnings grow tax-free in a Roth IRA, which is an incredible benefit!

Find more detailed information about Roth IRA rules and requirements here.

Roth IRA Benefits

The absolute best benefit of a Roth IRA is that it grows tax-free.

Since you’ve already paid taxes on the money you contribute, all of your earnings are accessible to you to tax-free once you turn 59 and a half.

This is a huge benefit, especially if you start contributing when you’re young and allow compound interest to do its thing for a long time.

For example, consider a Roth IRA and a traditional 401k that both have a balance of one million dollars.

The traditional 401k was funded with pre-tax dollars, meaning that taxes have not been paid yet and are due at the time of withdrawal.

The Roth, on the other hand, already had taxes paid at the time of contribution. The money available in the Roth IRA is the full one million dollars.

The money available to you in the traditional 401k is one million dollars minus taxes. Your one million dollars in a traditional 401k quickly becomes only $650,000 – $700,000, depending on your tax bracket.

Another perk of a Roth IRA is that you can withdraw your contributions without penalty at any time for any reason, once you’ve held the account for 5 years. Do this in a 401k and you will pay taxes and an additional 10% penalty.

Definitely don’t withdraw early unless something really bad happens. Since a Roth IRA has such a small contribution limit, you don’t want to “waste” that tax-free growth benefit if you can help it.

How to Open a Roth IRA

Now that you’re an expert on Roth IRA’s and are eligible to contribute, it’s time to open one of your own!

Here’s a simple 4-step process that can be done in 15 minutes or less!

1. Choose a Brokerage

Opening the account is as simple as opening an online bank account. I use TD Ameritrade, but you can go with any brokerage.

The brokerage is less important than the investments, so just pick one and get going!

Fidelity, Vanguard, or TD Ameritrade are all solid options.

You will need your driver’s license number, social security number, bank information, and employment information (potentially).

It takes less than $50 to start the account, so don’t wait until “you have enough money” to start investing.

You’ll also name beneficiaries of the account if something were to happen to you. You’ll need their name, birthday, and social security number.

2. Transfer Money

Once you’ve gotten your account open, it’s time to transfer money!

Doing an ACH transfer directly from your bank is typically the best way to do this. Select the amount you want to transfer and the “contribution year,” if you’re eligible. You have until April 15th of the following year to max out your Roth IRA (i.e. contributing the full $6000 amount).

Let’s say it’s February 2021 and you want to transfer $500 into your newly-opened Roth IRA. Since it’s before the April 15th deadline, you can choose if you want that $500 to count toward the 2020 or 2021 limit.

I’d recommend selecting the previous year (assuming you haven’t already maxed out the previous year).

You have the rest of the current year to hit the $6000 limit, so get those contributions in for last year before the deadline if you can!

3. Purchase Investments

Contributing money into a Roth IRA isn’t investing! You have to purchase investments inside the account, after you transfer money.

This is a common mistake I see a lot of new investors make (heck, I even did this myself)! You’ll open the account, transfer money, and everything is all good, right?

Not exactly. You have to ETF’s, mutual funds, bonds, stocks, etc with that money you transferred in to the account.

Remember how we said that the Roth IRA itself is a basket, and you need to fill it with eggs? It’s time to pick your eggs!

There are so many different funds out there and it’s easy to overanalyze and spend hours researching the best ones.

Don’t get too intimidated here, investing isn’t as complicated as a lot of people make it seem (I’m looking at you, financial advisors).

I recommend starting out with 1-3 low-cost index funds (keep reading for more info on these).

If you’re nervous about investing, start with a small amount of money until you get more comfortable with it.

Remember that you don’t need to know absolutely everything right now. Picking out one index fund and setting up a small automatic transfer each month is a great start!

You can change your strategy at any time as you learn more information!

And if you want to learn everything you need to know about investing, index funds, how the stock market works, etc, I highly recommend Personal Finance Club’s Index fund investing course.

It is the most affordable course on the market and will save you so much time when figuring out how to get started investing and building wealth.

Check out the course here, or click on the photo below!

how to build wealth by investing in index funds

4. Turn on Dividend Reinvestment

A dividend is a recurring small payment that shareholders recieve for owning stock. These get paid out monthly, quarterly, or yearly, depending on the stock.

You’ll want to make sure those dividend payments get reinvested into the funds inside of your Roth IRA. When you look at the overall returns on an investment, part of that return is due to dividends being reinvested back into the fund.

The last thing you want is for your dividends to be sitting in your account in cash, NOT earning you more money.

Simply check the “dividend reinvestment” box when purchasing an index fund and you’ll be good to go!

Don’t hesitate to call customer service if you need help with this!

Mutual Funds vs. ETF’s

It’s easy to get confused by investing jargon with terms like mutual funds, index funds, and ETF’s (exchange-traded funds). Here’s a quick description of the differences between mutual funds and ETF’s:

A mutual fund is a collection of stocks and bonds that allow someone to purchase one fund and get immediate diversification across several different companies and assets. Mutual funds can be actively or passively managed.

Actively managed funds usually mean high management fees in an attempt to “beat the market index.”

Passively managed funds simply aim to track the market index, not necessarily beat it. Therefore, passively-managed funds have much lower fees than their actively-managed counterparts.

You’ll usually hear passively managed funds referred to as index funds.

Mutual funds sometimes have minimum investment requirements. This can be anywhere from $500 to $10,000, depending on the fund.

Mutual funds only get traded once per day, so you can automate your investing. You can set up automatic transfers into mutual funds each month if you’re looking for a “set-it-and-forget-it strategy.”

An ETF (exchange-traded fund) is basically a mutual fund that is traded like a stock. ETF’s are usually passively managed, but there are some actively-managed ETF’s.

Unlike mutual funds, ETF’s don’t have minimum investment requirements. The “minimum investment” is the cost of one share.

You must buy ETF’s in whole-number shares. For example, if 1 share of an ETF costs $70 and you have $100 to invest, you can only buy one share and will have $30 left over in cash.

The price of one share of an ETF varies throughout the day, just like a stock does. You cannot automate investing in ETF’s because of this.

Mutual funds and ETF’s have their own unique benefits. Neither one is better than the other. I have both types of investments spread across my 401k, Roth IRA, and HSA.

Index Funds 101

An index fund is passively managed with the goal of matching the market index it tracks. Index funds can exist as mutual funds or ETF’s.

Index funds also have low fees since they are passively managed.

In a nutshell, all index funds are mutual funds and ETF’s, but not all mutual funds and ETF’s are index funds.

I love index funds for beginners because of their low fees and broad range of stocks in a single package.

Fees eat away at your returns, so you’ll want to find good index funds with low fees. A .5% fee can really add up to a huge amount of money over time!

There are a ton of actively-managed funds out there that claim to beat the market, but don’t actually beat the market.

What if the guy who rocks at managing the fund and beats the market year after year retires, and the next person sucks? I personally don’t want to manage my investments down to that level of detail, so I stick with passively-managed index funds!

S&P 500 Index Funds

The S&P 500 is a mix of the 500 largest companies in the US. Investing in one of these index funds means you’ll be invested 100% in stocks. Some people may say a 100% stock portfolio is too risky, but I disagree.

In order for you to lose money in the long term in an S&P 500 index fund, every one of the 500 largest US companies would have to go bankrupt at the same time. That means no Apple, Google, Ford, or Chase Bank.

Seems pretty unlikely, huh?

In the near-impossible scenario that this did happen, your savings accounts and US currency would be completely worthless, so your retirement account would be the least of your worries!

The S&P 500 is a great index with solid returns long-term. I personally invest in Vanguard’s S&P 500 ETF index fund inside my Roth IRA. The expense ratio for this fund is .03%, which is only 30 cents per $1000 invested!

Check out this chart for a 90-year history of the S&P 500.

It’s really difficult to find an actively-managed fund that beats the S&P 500 without paying a high management fee. 99% of the time, the “higher returns” promised don’t compensate for the fee they charge.

Stick to low-cost index funds and you’ll be just fine!

Continue Investing Early & Often

I hope this post helped you open you Roth IRA and get started with investing. The hard part is done!

All you need to do is focus on maxing that thing out each year, and you’ll be a tax-free millionaire in 30 years!

Remember that investing is a long-term game. Don’t get worried about short-term market fluctuations or temporary downturns. Leave your money alone and don’t touch it during a recession!

If anything, you should invest more during a recession because everything is on sale!

Don’t let your broke uncle try to explain to you his super complex investing strategy that’s “projected to beat the market.”

No one can predict the market, so buy funds with solid returns, low fees, and a proven history and hold them for the long-term.

The buy and hold strategy is so important. 80% of day traders lose money over the course of a year. Plus, you probably have better things to do with your time anyway!

As you hold the account for a while and keep learning and contributing, you can always change your strategy.

As a beginner, getting in the market early and making consistent contributions is what’s important now.

Make a budget (grab a copy of this template if you need some help) so you can figure out how much you can contribute to your Roth IRA each month. And then keep contributing consistently over time.

Your strategy may change as you get older and that’s okay! Just don’t let the fear of not knowing everything keep you from missing out on growing your money right now.

Keep your strategy simple, don’t let the news and temporary downturns scare you, and buy and hold. You’re in this for the long haul.

Let me know what index funds you’re buying in your Roth IRA in the comments below!

-Megan