Beginners guide to Roth IRAs and index investing: A Thread

So before I start, I want to say there are many different types of investments (real estate, stocks, bonds, mutual funds, businesses, etc.). For the sake of this thread I will be focusing on index funds because they’re one of the most effective and easiest investment types.

Some definitions: a Roth IRA is a tax advantages individual retirement account. The Roth part signifies that it’s funded with post-tax income. This is great because it allows your investments to grow tax free and allows you to make tax free withdrawals after 59 1/2

The IRA part indicates that it’s an account individuals can open/manage away from an employer. This is different from a 401K because 401Ks are connected to your employer. You can’t start one by yourself (unless you own a business - I’m not going to touch on that in this thread)

A Roth IRA (or traditional IRA or 401K) is an investment vehicle. It is NOT an investment in and of itself. It’s a place that you can out you’re investments to allow for tax free growth. There are some caveats to them though.

1) You can only invest in an Roth IRA with actual taxed income, so you’re income has to come from a job (they recently changed the law to allow grad students with fellowships to also contribute to them). There are also income limits on them.

For a single person, your adjusted gross income has to be below $139,000. For a married couple, your adjusted gross income has to be below $203,000. There are some work around a to these rules with Roth conversion ladders, but I won’t get into that in this thread.

The amount you can contribute to a Roth IRA each year changes, but for 2019 and 2020, the limit was $6000 (it was $5500 in 2018). If you’re over 50 you can do additional catch up contributions of up to $1000

The reason that Roth IRAs are so great is because of the tax free growth and withdrawals after 59 1/2. A Roth IRA can make you a tax free millionaire.

For example, if you max out your Roth IRA ($6000 or $500/month) from age 25 to age 65 (40 years) at an 8% annual return, you will have approvimately $1.7 million that’s completely tax free at retirement.

If you used the 4% rule, that means you could have a guaranteed retirement income of around $68,000 that would likely never run out (based on the trinity study)

Side note: the 4% rule basically says that if you save 25 times the amount you spend a year, then you can withdraw 4% of that amount every year pretty much indefinitely. Ex. If you spend $40,000 a year, then $1 million will allow you to spend $40K almost indefinitely

Back to Roth IRAs - they’re a great tool for investors, especially younger people. You don’t have to start out maxing it out, but compound interest is really your best friend when it comes to investing.

There are other rules and exceptions for Roth IRAs, but the basics are that it’s an investment vehicle that allows you to invest taxed income that grows tax free and allows you to make tax free withdrawals at age 59 1/2.

Pretty much anyone can open one (speaking for US citizens, not sure about non citizens), you just have to have a social security number and be able to prove that you made taxed income.

Some parents open custodial Roth IRAs for their children and try to make their children employees, but I know there are stipulations around that. If you want to do that, speak to an accountant lol.

If you’re over 18, you can open one on your own. If you’re under 18 you’ll have to get your parents to open one for you as a custodial account.

Moving onto index funds. I love index funds. They’re a passive investment strategy that allows you to get returns that match the market and they’re tax efficient.

An index fund is a passively managed mutual fund (collection of stocks) that matches a specific index. Index examples include the S&P 500 (largest 500 companies in the US) and the Total Stock Market (every public ally traded company in the US).

*publically. Index funds allow you to invest in a broad range of stocks in one place. Because they’re passively managed, the have lower expense ratios (fees associated with running the fund) and they are tax efficient.

These features mean that you can easily diversify your portfolio (invest in a lot of different companies and industries) and maximize your returns. It’s the best of both worlds.

If you’re interested in reading about why they’re so great, I recommend The Little Book of Common Sense Investing by John Bogle. Bogle is the founder of Vanguard and is one of the fathers of index investing. He breaks down how index funds outperform actively managed mutual funds

I personally am invested in the Total Stock Market Index Fund at Vanguard. I have that fund contained in my Roth IRA. My returns mimick what the market does. When the market was down in March/April, so were my returns. Now that it’s going back up, so are my returns.

Index funds help alleviate some of the risks with investing. Since you’re invested in everything, if one company goes bankrupt, you’re whole portfolio won’t be at risk. Statistically speaking, picking stocks is a losing game.

Even the best stock traders/fund managers can’t consistently beat the markets returns. If you can’t beat them, might as well join them.

Like I said, I’m invested through Vanguard, but there are plenty of other companies with funds (Fidelity, Charles Schwab, etc.) you’ll have to research to pick the best one for you.

Vanguard has super low expense ratios (mine is .04%). That means I’m charged 40 cent for every $1000 I have invested. Actively managed funds typically charge around 1% and have other fees associated with them. That’s $10 per every $1000. Huge difference.

There are a few different ways to invest in index funds. You can do the basic way which is to find a fund and put money into it. This way typically requires a minimum. At Vanguard the minimum is $3000.

There’s also the option of investing using ETFs. Exchange traded funds essentially track the same indexes, but you buy and sell them like individual stocks. At Vanguard, the ETF of the fund I’m invested in is ~$171 per share. So for $171 you’ll be invested in every company.

If that’s too high of a barrier to entry, then you can look into things like Stash or Acorns. They typically have index funds that you can buy fractional shares of that way you can start with < $10.

It doesn’t matter how much you start with, as long as you start. Compound interest is your best friend and the more time you give it, the better it will work for you. $1 invested at an 8% return becomes $21.72 in 40 years.

That’s not a lot, but it demonstrates how your money can grow. $120 invested a year ($10/month) at an 8% return becomes ~$34,000 at the end of 40 years.

Again these are small numbers, but I’m trying to show how compound interest can work in your favor even if you don’t have a lot to invest. Every dollar counts.

Summary: index funds are a passively managed collection of stocks that track a specific index. They allow you to diversify your portfolio and have low expense ratios that allow you to maximize your returns. You just set them and forget them and allow them to grow over time.

Tips for investing:
1. Only invest money that you won’t need in the next 5+ years
2. Set it and forget it
3. Invest consistently to take advantage of dollar cost averaging
4. Pay attention to fees
5. Invest in tax advantaged accounts 1st