Why You Should Start a Roth IRA

This post explains how you can use a Roth IRA to become a millionaire while legally sheltering yourself from the Internal Revenue System (IRS).

A Roth IRA has become increasingly important with the uncertain future of social security and the decline of corporate pension plans. Our financial security in retirement is becoming more dependent on our individual decisions.

Compound Interest Explained

Before exploring the details of a Roth IRA and its advantages, we need to understand compound interest, which is directly connected to the benefits Roth IRAs offer.

If you start preparing for retirement while you're young, you'll need much less money to reach a secure retirement with over $1 million. This happens because of "compound interest."

Albert Einstein called compound interest the "8th wonder of the world" for good reason.

Compound interest means your interest earns its own interest over time. It's one of the most powerful forces in investing. When you use compound interest to your advantage, it makes a huge difference in the long term.

Compounding Effect Example

The compounding effect creates exponential growth with anything that has continuous percentage growth.

For example, if you invested $1,000 in the stock market, such as in an ETF that tracks the S&P 500, and it grew 10% every year (a realistic growth percentage), your $1,000 would become $1,100 by year-end.

Instead of taking out your $100 profit, you leave it invested and experience another 10% growth the next year. This turns your $1,100 into $1,210. In total, you've made $210 in two years (with $110 coming in the second year).

In ten years, with a steady 10% return, you would have $2,593.74, assuming no additional investments or dividends!

You can verify this using a compound interest calculator. See the visualization below:

The two main ingredients of compound interest are time and money. Adding more of either magnifies the effect. Every year you keep your profits invested, the more your initial investment grows at no additional cost. Furthermore, the more you invest in the stock market, the more your investment can compound and grow.

The stock market won't consistently rise 10% each year, but historically it has had more years of growth than decline.

You can see this pattern in the chart below:

Now that you understand compound interest, let's explore what a Roth IRA is and why you should use it.

Roth IRA Explained

A Roth IRA is an investment account that can provide you with millions of dollars at retirement, completely tax free! You can have both a 401(k) and a Roth IRA, and in most cases, it makes sense to have both.

The Roth IRA is funded with post-tax income, while the 401(k) is funded with pre-tax income. With a 401(k), you're taxed on growth when you withdraw the money. With a Roth IRA, you're taxed on contributions when you put money in.

You can withdraw your contributions from a Roth IRA anytime without penalties or taxes. You just can't touch the earnings until retirement age. A Roth IRA rewards delayed gratification, whereas a 401(k) offers more immediate tax benefits. Both have unique advantages that smart investors can use.

It's important not to confuse a Roth IRA with traditional brokerage accounts. In traditional brokerage accounts, you deposit taxed income and then pay taxes again on any capital gains (including dividends) when you sell investments.

Currently, most Americans fall in the 15% tax bracket for capital gains. This means if you had $1,000,000 in capital gains in a traditional brokerage account, you'd owe $150,000 in taxes! However, with a Roth IRA, you'd owe $0 on those gains, which highlights why Roth IRAs are so valuable. You won't have to worry about a significant tax bill later.

These Roth IRA benefits include:

• Tax-free retirement income.
• No required minimum distributions.
• High income loophole: "Backdoor Roth."
• Access to contributions if needed without penalties (unlike 401k plans)
• $10,000 in earnings can go towards first home purchase.

Roth IRA Restrictions

Clearly, the tax-free gains from a Roth IRA make it highly beneficial for securing retirement. However, since the government is providing a way for you to pay less in taxes, there are strict rules about what you can and cannot do with your Roth IRA.

Below are the three main restrictions for Roth IRAs:

Restriction #1: Annual Contribution Limit

The first major restriction that a Roth IRA presents is the yearly contribution limit. As of 2025, the annual contribution limit to a Roth IRA is $7,000 (or $8000 if you are 50 or older).

This means that after you have deposited $7,000 into your Roth IRA, you will not be allowed to make another deposit until the start of the next taxable period.

Any additional capital you wanted to invest would need to be deposited into a traditional brokerage account and would not receive the same tax-advantaged treatment of a Roth IRA.

Restriction #2: You Cannot Withdraw Gains

Perhaps the most significant restriction is that you cannot withdraw any of your gains until age 59½.

If you withdraw earnings (the gains beyond your deposits) before age 59½, those distributions will be taxed as ordinary income and may incur a 10% penalty. This is definitely something to avoid if possible.

A common misconception is that this restriction means you cannot withdraw any money from your account until age 59½. This is not true—the rule only applies to investment earnings. You can withdraw your original contributions at any time without taxes or penalties.

Restriction #3: Income Threshold Limitations

The final major restriction is that once you exceed a certain income threshold, you're no longer eligible to contribute directly to a Roth IRA.

For 2025, if you make more than $150,000 as a single person or $245,000 as a married couple, you cannot contribute to a Roth IRA. This must be earned income, which essentially means income from employment.

Fortunately, there's a workaround called the "backdoor Roth IRA strategy." This involves opening a Traditional IRA and converting it to a Roth IRA. You can also roll over a Traditional IRA or 401(k) into a Roth IRA if you choose.

This income cap is another reason Roth IRAs are great for young people. When you're around 20 years old, you likely aren't making over $150,000 per year and can freely contribute to a Roth IRA, building your retirement foundation early.

The $5-a-Day Strategy

Now that you understand compound interest and Roth IRAs, we can combine these financial concepts to create the $5-a-day strategy, which works well for those with limited income.

The $5-a-day strategy is simple. Every day, you deposit $5 into your Roth IRA, or make one larger $150 deposit monthly to save time. You then invest your Roth IRA balance in low-cost S&P 500 index funds.

After a full year, you would have deposited $1,825 (365 × $5) into your Roth IRA. Assuming an 8% average return (the conservative average for the stock market), after 50 years you'd have over $1.1 million in your Roth IRA waiting for your retirement (after age 59½).

If you want to reach seven figures in less time, simply increase the amount from $5 to $10 or $20, or invest up to the annual contribution limit. This can nearly cut the required time in half.

The Best Allocation Strategy (For Most People)

In most cases, this strategy makes sense for your investing plan, assuming you already have an emergency fund in place:

1. Contribute the maximum to your 401(k) that your employer will match: If your company offers a match, this is free money you should take advantage of.
2. Maximize contributions to a Roth IRA: For 2025, the limit is $7,000. If you're over age 50, it's $8,000 due to catch-up provisions. These contribution limits typically increase every few years.
3. Put excess money in a taxable brokerage account: You can also consider a Traditional IRA or different retirement account. Your choice depends on when you plan to use this money.

When in doubt, look for a fee-only financial advisor who doesn't earn commissions from your investments.

Best Strategy Example

Imagine you pay $3,000 monthly for living expenses. Your employer matches 401(k) contributions at $0.50 per dollar up to 6% of your salary. At this job, you earn $50,000 annually.

Here's how you might allocate your savings given these parameters:

1. $18,000: High-yield online savings account (emergency fund).
2. $3,000/year: 401(k) contribution (Company adds an additional $1,500).
3. $6,000/year: Roth IRA contribution.
4. $2,500/year: Taxable brokerage account.

Although this is a simplified example, individuals earning $50,000 yearly can follow this strategy (or modify it based on their needs) to work toward financial independence.

The Bottom Line

In summary, you should begin investing in your Roth IRA as soon as possible, and you'll thank yourself later! Even if you eventually exceed the Roth IRA contribution limit, the money already in your Roth IRA will continue to grow and compound tax-free. Only after maximizing your Roth IRA and other tax-advantaged accounts should you start investing in a taxable brokerage account.