Yesterday, a friend asked about how to get a Roth IRA started, and it was clear that there were a few points that were misunderstood when it came to investing for retirement. Since these very questions are about 80% of the ones I get asked in the College of Financial Knowledge, I decided to post my thoughts here.
A Roth IRA is just an account with special rules. I think of different accounts like buckets. Each account (checking, savings, Roth, Individual Brokerage…etc.) has its own special rules, for tax purposes. When you contribute to a Roth IRA you are making a declaration about that money, which is “this money will not be used until I am 59 1/2 years old”. In return, the government allows you to pay taxes on the money upfront, and does not charge you capital gains on the back end, saving you about 15% of your portfolio value at maturity.
Remember, opening up a Roth IRA doesn’t do anything. You now just have an empty bucket. You need to put things in it. I’ve heard too many people say that they have “invested in a Roth IRA” to let this point go without emphasis. So what do you put in it? This brings to light the question of individual stocks, ETF’s, and mutual funds. A mutual fund is just an aggregate of several different stocks and/or bonds in a particular sector, I.e. technology. You usually get about 30 in a fund. Thus, you are pretty much instantly diversified. For that privilege you pay something called an “expense ratio”. Vanguard has very low expense ratios which is great. However, before you dive into mutual funds you might want to look into something called an ETF, or Exchange Traded Fund. They are like mutual funds in every way except they are traded in real time and have better tax consequences. Simply put, it beats the mutual fund with no real downsides. I like to think of them as the mutual funds of the future.
Before you go off and put your coffee can full of cash into a Roth IRA, there are more rules. Most importantly, most people can only contribute $6000 per year towards a Roth (in 2020), so make sure your combined contributions don’t exceed that; check the IRS rules for your particular limit. The last point is the fun part: within the “bucket” of your Roth you can trade stocks without tax consequences AS LONG AS the money does not leave the account. This is not true for any other investment. Enjoy.
The Investment Club 