We are nearing the beginning of a new year, making it the perfect time to learn how to better our future selves financially. One of the most underrated yet effective wealth-building tools is the Roth IRA, a unique retirement plan designed to help people save for retirement.
However, the rules of a Roth IRA make it critical that you start using it as soon as possible to get the most out of it. Here is how you can step up your financial game with a Roth IRA in 2022.
What is a Roth IRA?
The U.S. government created the Roth IRA in 1998. It's an individual retirement account where people can invest income that they've already paid income tax on (known as "take-home pay") to withdraw tax-free in retirement later in life.
Image source: Getty Images
All you need to create and contribute to a Roth IRA is taxable income under certain income limits; "high earners" who make very high wages are not allowed to contribute to a Roth IRA, though there is currently a workaround for this.
The beauty of a Roth IRA is that it gives you the ability to invest money into it, grow that money, and then pay zero taxes on the gains. Every penny that comes out of a Roth IRA (when withdrawn according to the rules) is yours to keep.
To successfully withdraw from your Roth IRA without penalty, you must be 59 1/2 years of age or older and have had the account open for at least five years. If you withdraw your gains earlier, potential penalties can be applied. Additionally, this is for your profits only; you can withdraw your original contributions at any time, making a Roth IRA a very flexible financial tool.
So how do you maximize the benefits of a Roth IRA?
Start early, and max it out
Roth IRAs are very unforgiving to people who procrastinate. There are contribution limits, meaning most people can invest just $6,000 per year. If you are 50 or older, you are allowed an additional $1,000 ($7,000 limit) to help you make up lost time.
This means that each year that goes by without contributing is a year lost forever. You cannot wait until you're older and invest tens of thousands of dollars per year to make up for it.
Image source: Federal Reserve Bank of St. Louis.
Years of skipping your Roth IRA contributions can add up to tens of thousands of dollars in lost gains because your money has less time to compound. If you're older, don't feel discouraged -- the best time to start is yesterday; the second-best time is today.
Different Roth IRA investing strategies
The flexibility of a Roth IRA gives you many options in how you want to manage your investments. If you want to take on less risk (and potential steep losses) because of the contribution limits, index funds are a great tool. There are funds like the Vanguard S&P 500 ETF (VOO 1.26%) built to mimic the S&P 500. If you are a little more aggressive, you can also consider growth-focused funds like the ARK Innovation ETF (ARKK 2.98%).
If you feel confident and can stomach the volatility of picking individual growth stocks to invest in, the potential reward can be huge. There aren't many better windfalls than picking a winning stock in your Roth IRA that multiplies tenfold or more in value and then having no tax bill for your massive profits.
If you want to create a passive stream of tax-free income, you could build a portfolio of dividend stocks in your Roth IRA. Dividends can be reinvested to turbocharge the compounding effect. Because there are no minimum withdrawals, you can leave the actual dividend stocks alone to keep growing and live off the dividend streams.
