Why You Need a Roth IRA
With this indispensable savings tool, your money grows tax-free, you can invest in almost anything and you get several cool perks. But open your account soon. You only have until April 17 to make contributions for 2005.
By Erin Burt
March 9, 2006
One of the smartest money moves a young person can make is to invest in a Roth IRA. Follow the rules and any money you put into one of these retirement-savings accounts grows absolutely tax free -- you won't owe Uncle Sam a dime as you let your savings accumulate, or when you cash it out in retirement. Plus, an IRA is more flexible than a 401(k) and other retirement plans because you can invest it in almost whatever you want, from stocks and mutual funds to bonds and real estate.
If you haven't yet opened this gift from Uncle Sam, do it now. You have until your tax return deadline -- April 17 this year -- to set up and make contributions for the previous tax year. The government sets a limit on how much you can contribute to a Roth -- currently up to $4,000 annually. That means you can invest $4,000 right now for 2005 and stash another four grand throughout 2006, giving you a solid start to your savings. The contribution limit rises to $5,000 in 2008.
The idea of saving on your taxes may seem a tad obscure, but it really can pay off big. If a 25-year-old contributes $4,000 each year until she retires and makes an average annual return of 8% on her investment, she'll have more than $1.1 million saved by the time she retires at age 65. And the money is all hers -- she won't have to give the IRS a cent of it if she waits until retirement to cash out. (Use this calculator to see how far your savings can take you. Enter "0" in the tax rate boxes to simulate the tax-exempt status of a Roth IRA.)
If that same 25-year-old invested that same $4,000 a year in a regular taxable account earning the same 8% return, she'd only have about $802,000 after 40 years if her earnings were taxed at 15%. That's more than one-fourth less money than if she'd gone with the Roth.
As with any government gift, the Roth IRA comes with a few strings attached. First, you can contribute to a Roth only if you have earned income from a job. Say you're in school, you're not working and you have a little extra money left over from your student loan or your parents gave you money. You cannot put it in a Roth. Also, you cannot save more than you made. So if you worked a summer job and made only $3,000, the most you can contribute to a Roth is $3,000.
It's also possible to make too much. You can contribute the full $4,000 as long as your income falls below $95,000 if you're single, and $150,000 if you're married filing a joint tax return. The contribution limit is then phased out incrementally if you make between $95,000 and $110,000 (single) or $150,000 and $160,000 (married-joint). (See IRS Publication 590 for more on calculating your contribution.) Make more than those upper limits, and you don't have to cash out the account -- you simply cannot contribute any more money to a Roth IRA.
If you expect to exceed the Roth income limits at some point during your career, you should open a Roth now while you're young and your salary is low enough to get in. If a 25-year-old saved $4,000 a year for only five years, then didn't contribute another dime for the next 35 years because his income was too high, that money would continue to grow -- to nearly $385,000 by the time he turned 65. That alone certainly won't be enough to retire on, but it'll be a nice tax-free bonus to his other retirement savings.
If the savings power, flexibility and tax-free status aren't enough to convince you of the Roth's virtues, Uncle Sam throws in a few extra perks, making the Roth an indispensable tool in a young adult's financial life.
You can take money out in a pinch. Although the purpose of a Roth is to save for retirement, and your money can grow only if you leave it in the account, you can withdraw your contributions at any time, tax free and without penalty -- and you don't have to pay it back, like you do with a 401(k). Of course, it's best to leave your money in the account so you can earn more money, and you really should have a separate emergency savings account on standby, but it's nice to know the Roth is there for you if you need it.
Notice we said you can take out your contributions at any time -- not your earnings. If you withdraw any of your earnings before age 59½, you'll trigger a tax bill on the money, plus you'll have to pay a 10% penalty. Ouch.
You can tap your Roth to buy your first home. The IRS lets you cash out up to $10,000 from your Roth IRA tax- and penalty-free -- which can include earnings -- to help you achieve the American dream. However, the account must have been opened for five years. So, if you open an account before April 17 this year, that can count for 2005. You could use tax-free money from your IRA to buy a house starting in January 2010. Wait until after the tax-day deadline, though, and it'll count for 2006 -- you'd have to wait until 2011 to buy a home. That $10,000 limit is per person, so couples could withdraw up to $20,000.
If you don't meet the five-year test, you still can take out the money for your home purchase, but you'll have to pay taxes on it. You won't have to pay the 10% early-withdrawal penalty, though.
You can use it to save for Junior's education. Many new parents don't know whether to save for retirement or the baby's college tuition. Hands down, retirement wins. There are loans to pay for college, but none to help fund your retirement. But starting a Roth is a great way to cover both bases, just in case. Focus on your retirement now, saving as much into a Roth as you can. And as your finances allow, consider opening a specific college-savings account for the new baby -- say, a Coverdell or 529 plan. Then, when the day comes for Junior to head off to school, you can assess whether you can afford to -- or need to -- sacrifice some of your retirement dollars to make it happen.
You can, of course, take out your contributions at any time to help pay the bill. If you dip into earnings, you'll owe taxes -- but you don't have to pay the 10% early-withdrawal penalty if you use the money for college. The Roth shouldn't be used as the sole savings vehicle for higher education, but it's nice to know you can use it if you need it.
How to open a Roth IRA
When you're just getting started investing, the Roth should be your first stop -- even before you open a regular, taxable account, or contribute to a workplace retirement-savings plan. The only exception is if your employer offers a match on your 401(k) contributions. That's free money you don't want to pass up. In that case, contribute enough to win the match, then send any extra money into a Roth IRA. (Yes, you can invest in both a Roth and a workplace retirement plan.)
You can invest your Roth IRA in almost anything -- stocks, bonds, mutual funds, CDs, or even real estate. It's easy to open an account. If you want to invest in stocks, go with a discount broker (see how different companies compare). For mutual funds, go with a fund company. For CDs or money market accounts, you can go through your bank.
Because you're young and have a long way to retirement, you'll want to invest in the stock market to get the highest returns over time. Rookie investors should stick to mutual funds that invest in stocks. They're easy to understand, you leave the stock-picking to the pros and they make it easy to spread your risk around several stocks or bonds without putting all your eggs in one basket.
Most mutual fund companies even lower their minimum investment requirements when you open an IRA. T. Rowe Price, for example, requires $2,500 to invest in a taxable account, but IRA investors need only $1,000 to get started -- or as little as $50 a month if you sign up with its automatic investing program.
Use Fund Finder to search for funds with low investment minimums and that meet your other criteria. Stick to no-load funds with low expense ratios (the average expense ratio for stock funds is about 1.5%). And check out How to Invest With $500 or Less for some specific low-cost fund recommendations, and for more information on diversifying and evaluating your investment options.
Many fund companies will let you open an account and make contributions online. Make sure you designate whether your contributions are for 2005 or 2006.
Not sure where to find the money to fund your account? Consider investing your tax refund. About 70% of us will get a refund this year, and last year the average check totaled more than $2,000. That cash would make a great start to your Roth.
Another way to fund your account is to put it on autopilot. Most banks and brokers will allow you to set up an automatic investment plan taking the money directly out of your bank account and putting it into your Roth. It's much easier to find the cash when it's considered already gone than if you have to make a physical effort to write the check each month.