Roth IRA – What is it, and why you should invest in one

You may or may not have heard of a Roth IRA before. So I wanted to walk you through what it is, how to open an account, and why everyone should invest in one. 

What is an IRA?

OK, first let’s talk about what an IRA is. IRA stands for individual retirement account. The first IRA in the US was created in 1974 as part of the Employee Retirement Income Security Act, and is known as the traditional IRA. The second type of IRA is known as the Roth IRA, and was introduced in 1997 as part of the Taxpayer Relief Act. You can contribute to either or both, but it cannot exceed the IRS limit when combined, which is $6000 for 2021.

Also, you cannot contribute more than you’ve earned that year. If you are 50 or older, you can contribute $7000 total. The deadline to contribute to any year is usually the day federal taxes are due the following year, e.g.  you could still contribute to 2018 until April 15, 2019. Rules are a bit different AC (After Covid). 

There are some key differences between these two accounts as outlined in the table below:

Roth IRATraditional IRA
post-tax contributionspre-tax contributions
contributions grow tax-free i.e. future withdrawals are not taxedcontributions grow tax-deferred i.e. future withdrawals are taxed as income
eligible if earning under certain income level, and contributions are phasedeligible for anyone with earned income
no immediate tax benefitscontributions reduce taxable income in the contribution year, if deductible
no required minimum distributionsrequired minimum distributions at age 72
contributions can be withdrawn tax-free and penalty-free at any time; earnings can be withdrawn 5 years after you’ve contributed for the first time in the account and after you’ve reached 59½ of agepre-retirement withdrawals are taxed and carry a 10% withdrawal penalty
good for people who currently are in a lower tax bracket than they will be when they retiregood for people who currently are in a higher tax bracket than they will be when they retire
Key differences between a Roth and a traditional IRA.

The important thing to note is that you can only contribute earned income. This becomes a bit confusing when you’re a grad student on a fellowship or an assistantship. Luckily, after the passing of the SECURE Act in 2019, non-tuition fellowship and stipends count as earned income when it comes to contributions to a Roth IRA. And if you get a W2 from your job, you have earned income. When I was on a research assistantship, I got a W2, so I was able to contribute to my Roth IRA.

Why should college and grad students contribute to a Roth IRA?

You might be in a lower tax bracket now than in the future, as you’ll likely earn more money after college and grad school. So contributing to a Roth IRA account makes sense when you’re still studying.

You might be thinking, why should you bother investing now, when you can wait until you get a nice job with a nice salary, and then start investing? Well, here’s where the magic of compound interest comes in.

When you invest your money in the stock market, you earn compound interest on your investments. Essentially, your money is making money, and that money is going to make more money, and so on. The longer your money is invested, the more time it has to earn interest. And time is money, my friend.

So how do you figure out what your initial investment will be worth in a few year’s time? Let’s say you initially invest $500 in an index fund that tracks the S&P 500, which earns, on average, about 7% interest per year after inflation. The formula to work out how much your money will be worth in 10 years time is:

F = P(1+i/n)nt

where F is the future value of your investment, P the present value, i is the interest rate, and n is the compounding frequency per year (so if your investment compounds annually, n=1), and t is the time expressed in years.

So taking that, your $500 is then worth: $500(1+0.07/1)10*1=$983.58 in 10 years. That’s almost double your money!

If you invest $500 a month for 30 years, your investment would be worth about $570,570.85. The money you put in every month works harder than it would when put in a savings account, where you might earn 0.5% interest at most in a high-yield savings account. And at some point, the interest that you generate from the earned interest alone will be more than those of your contributions.

This is why people should start investing at a young age, and continue to invest in a consistent manner. You want that compounding magic to work in your favor, which requires TIME. And what better time to start getting into the habit of investing when you’re young and you might have started working a part-time job?

OK, you’ve convinced me. How do I open one?

First, make sure you’ve budgeted your money and have money leftover from savings after all your bills and needs have been met. I have a line in my budget that’s just for investing so I set money aside for it when I get my paycheck.

For first-time investors, I would suggest opening an account on Fidelity. You sign up on fidelity.com by clicking on “Open an Account”, click on “Open Now” under Roth IRA, select “yes” or “no” if you’re a fidelity customer, and fill out your information. You’ll also need your social security number, birth date, and contact information.

Fidelity is great because most of the mutual and index funds have no minimum investment amount, whereas brokerages like Vanguard usually have a minimum investment amount of $1000 or $3000, depending on which fund you choose. I also like Fidelity because they’ve rolled out a few funds with zero expense ratio, which is a management fee you pay to the brokerage in order to invest in the fund. The lower the expense ratio, the better, since you get to keep more of your money. And what’s better than 0% expense ratio?

It’s open, now what?

So, if you’ve opened an account on Fidelity, you will need to link your bank account to the Roth IRA. Once you’ve linked it, transfer the amount of money you would like to invest in the account. For now, choose whatever amount you can afford. The important thing is to get started and getting in the habit of investing in your future.

You’ll see that the money you’ve contributed to your Roth IRA is going into a Core position. This is essentially a money market account called SPAXX, which is NOT invested. You will need to choose an investment fund to trade this core position with. For most investors, a total market index fund is usually a good investment fund to start with.

On Fidelity, I chose the FZROX fund, which is the Fidelity zero total market index. It has a 0% expense ratio, no minimum investment amount, and contains more than 2600 different US stocks making for a highly diversified fund. On your Roth IRA account, click on Trade, select Mutual Funds, the Roth IRA account, and type in the ticker symbol FZROX. Select Buy as your action and the dollar amount you have in your core position. Then click Preview Order, and finally, Place Order. You just invested in your Roth IRA account!

What do I do next?

Now you make investing a priority in your budget. I started with $25 a month, because that’s all I could afford when I first started investing. Over time, I built my way up to $500 a month so I could meet the contribution limit. And I set an auto-transfer and auto-invest in my account so I don’t have to think about investing.

I would also suggest reading more on investing in general. Some books that I highly recommend are:

  • The simple path to wealth – JL Collins
  • Bogleheads’ guide to investing – Mel Lindauer, Michael LeBoeuf, and Taylor Larimore
  • I will teach you to be rich – Ramit Sethi

There are also a lot of resources online, such as:

Finally, I wish you the best on your investing journey. By starting a Roth IRA in grad school or even in undergrad, you’re well on your way to becoming a financially secure.

Disclaimer: I’m not a tax expert, and any IRA rules are subject to that year’s IRS rules. So please do your due diligence and read up.

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