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human
ELI5: How does a Roth IRA work?

My brother's been telling me about using a Roth IRA and using mutual funds to become a millionaire. Someone wanna help explain what a Roth IRA is and how it works?
gpt
Okay, so first let's talk about what a *security* is. A security is, in the most generic sense, a thing which you buy today for some price $X, and which you sell in the future for some price $Y, with the goal being that Y should be greater than X. It's a simple idea: You buy low, and then you sell high, and you end up making money on the deal.

One type of security is a *share in a mutual fund.* You know how you can buy shares of stock which give you an ownership stake in a company? Like imagine you own a company that makes widgets. You can divide the ownership of that company up into pieces, called shares, and then give some to yourself and sell the rest. These shares are securities, in the sense that we defined above: They can be bought, held on to for a time, then sold at a different, and ideally higher, price than what was originally paid for them, because in the time between buying and selling the shares became more valuable.

A mutual fund works *kind of* like that. It's basically a pool of money which is used to buy securities, but rather than each member of the pool directly owning some of the securities, the securities are owned by the *fund itself*, and the members of the pool own *shares in the fund.* You might buy a share of a mutual fund which owns shares in the widget company we described above, but then sells those shares and uses the money to buy shares in a different company, one that makes gadgets. When those shares in the gadget company have gained in value a bit, those shares are sold and the money's used to buy shares in yet another company, this one making thingamagigs. And so on, and so on … but you, as a shareholder in the fund, don't need to worry about any of that. All you need to know is that the shares you own in the fund as a whole are accruing value over time through the wise buying and selling of securities on the part of the fund manager, the person responsible for managing the fund's portfolio and increasing its value over time.

Of course, the basic rule of buying and selling assets applies to mutual funds as well: You are not guaranteed to make money. In fact, you aren't even guaranteed to *keep* the money you start out with. It's possible for mutual funds to lose value over time, meaning if you put $10,000 into one right now, a year from now your share of the fund might only be worth $9,000. So why would you put money into a mutual fund rather than just putting it into an interest-bearing deposit account, or buying bonds with it? Because an interest-bearing deposit account or bond investment might, over a year, turn your $10,000 into $10,300 if you get a good rate … while a mutual fund *has a chance* of turning your $10,000 into $12,000 in the same time. There's a chance for bigger returns, balanced by a chance that you might lose value over time. (This is pretty rare, though. Most mutual funds are well-managed, and give you returns that are *at least* somewhat better than what you could get from risk-free investing over the same period of time.)

Now the question becomes, how do you go about buying shares in a mutual fund? Well, the most obvious way is just to walk into the office of some mutual fund someplace and write them a check. But when you do this, you need to know two things. First, the money you use to buy the shares of that fund has *already been taxed.* If you earned $30,000 last year and paid $10,000 of it in taxes, the $20,000 you have left is all you have to buy shares of the fund with.

The other thing to know is that in the future, when you cash out of the mutual fund, *you're going to be taxed again* on the *profits* you made from your investment. The rate at which those profits are taxed depends on how long you stayed in the fund and how much you made when you got out, but the point is the government is going to take a cut.

The way around this is to structure your investment as a Roth IRA. IRA stands for "individual retirement account", and a Roth IRA is a type of IRA (named for the guy in the Senate who sponsored the law that created it). The virtue of structuring your investment as a Roth IRA is that if you follow certain rules, you can get *out* of having to pay taxes on the profit the investment pays you. These rules are pretty complicated, and involve contribution limits — a limit to how much you can put into your investment every year — and seasoning times — how long you have to leave the money in the investment before you can take it out. But as long as you work within those rules, a Roth IRA backed by a well-managed mutual fund can be a really good way to store your money, protect its value against inflation (by getting a return on your investment that's equal to the rate of inflation), and make a decent profit for your trouble.