Knowing how an investor might open one of these tax-advantaged accounts will shed more light on how they work and help you understand more about Roth IRA accounts as compared to mutual funds.
How a Roth IRA Works
A Roth IRA is a type of retirement account created by Congress. It differs from a traditional IRA in several notable ways. You can put aside a certain amount of money each year, up to a maximum that’s known as the “contribution limit.” The 2022 Roth IRA contribution limits are $6,000 per person for anyone age 49 or younger and $7,000 per person for anyone age 50 or older, which includes a $1,000 catch-up contribution allowance. For 2023, the limits are $6,500 for those 49 and younger and $7,500 for those 50 and older. The money you contribute to a Roth IRA isn’t tax-deductible. It’s like adding it to a savings account in this respect. But almost all forms of income within the Roth IRA, including dividends, interest, and capital gains, can grow completely tax-free. Imagine that you were to invest your money in a Roth IRA throughout your lifetime. Suppose you ended up with $5 million in the account and put it all in corporate bonds at a time when they were yielding 7.5% for 10-year maturities. You’d be collecting $375,000 in interest every year within your Roth IRA. You could withdraw all $375,000 of that money and never pay a single penny in taxes on it under the present rules, as long as you were age 59 1/2 or older and held the account for at least five years. Or you could withdraw the entire $5 million tax-free.
Roth IRA Eligibility Limits
Congress sets income limits on eligibility to contribute to a Roth IRA. You aren’t eligible to contribute to a Roth IRA under the guidelines in tax year 2023 if you’re single and earn $153,000, or $228,000 for couples who are married filing jointly. For the 2022 tax year, the limits are $144,000 for singles and $214,000 for married taxpayers who file jointly. You do have the option of contributing to a traditional IRA if you earn more than this because traditional IRAs don’t have eligibility income limits. You can then convert the account to a Roth IRA. This is known as a “backdoor Roth IRA.”
How To Open a Roth IRA
Different types of institutions offer their own versions of Roth IRAs. A Roth from a discount broker such as Charles Schwab lets you buy practically any type of investment, including stocks, bonds, and mutual funds. A Roth IRA from a bank might only let you buy certificates of deposit or money market securities. A Roth IRA from a mutual fund company will probably only let you buy mutual funds offered by the mutual fund company itself.
Opening a Roth IRA at a Bank or Credit Union
Suppose you were to walk into your local credit union and open a Roth IRA. The credit union doesn’t have an investment division, so it only allows you to contribute your money to certificates of deposit or a money market account. You can’t buy any stocks, bonds, mutual funds, or real estate through this Roth IRA because the servicer (the credit union) doesn’t offer these among its provided services. Some but not all banks and credit unions also have brokerage divisions that allow you to buy investments for your Roth IRA that include stocks, bonds, and mutual funds from other companies. Wells Fargo and Bank of America fall into this camp.
Opening a Roth IRA Directly With a Mutual Fund Company
Now let’s say that you want to buy shares of the Tweedy, Browne International Value Fund, ticker symbol TBGVX. You go to the mutual fund company’s website, download an application, check the “Roth IRA” box, and write a check for $6,000. The mutual fund company opens a Roth IRA for you, but the only investments the account can hold are shares of funds managed by Tweedy, Browne Company LLC, the mutual fund manager. You’ll have to make other arrangements if you ever want to buy shares of a Vanguard S&P 500 index fund or Coca-Cola. Just like banks and credit unions, some (but not all mutual fund companies also have brokerage divisions that allow you to buy investments for your Roth IRA that include stocks, bonds, and mutual funds from other companies. Vanguard and Fidelity fall into this camp.
Opening a Roth IRA Through a Direct Stock Purchase Plan
Now you decide to spend the rest of your life buying shares of The Coca-Cola Company and holding them tax-free through a Roth IRA. You don’t want to invest in any other stock or mutual fund, so you sign up for the direct stock purchase plan that has a Roth IRA option. After completing the application, opening the account, and setting up a link between your checking account and Roth IRA, the beverage giant’s transfer agent begins making automatic monthly withdrawals from your checking account to buy more shares of Coca-Cola at a very low cost. They’re typically less than $2 per transaction. You’ll never pay any taxes on your Coca-Cola dividends because the stock is held in the Roth IRA.
Opening a Roth IRA Through a Brokerage Firm
Perhaps the most popular option is to open a Roth IRA with a brokerage firm such as Charles Schwab, E-Trade, or T.D. Ameritrade. It works exactly like opening an ordinary brokerage account. You can typically buy any stock you want, any bond you want, any mutual fund you want, or any exchange-traded fund you want, often for a commission well under $10 per trade. For example, you could have a Roth IRA at Schwab that holds Vanguard funds, shares of General Electric, and some certificates of deposit issued by a bank in your state. In addition to enjoying the convenience of having all of your information on a single account statement, many brokers will reinvest your dividends for free.
