Ready to start investing on your own? Then a Roth IRA is the first place to look.
Before I took a job at SmartMoney Magazine, terms like 401(k), Traditional IRA, and Roth IRA were all investorbabble to me. I didn’t know what they were and—to be quite honest—at 22 and with no financial smarts of my own, I didn’t’ really care. I was in a ton of debt (and I was 22), so I didn’t see retirement as a real priority.
Today, it’s a different story. I’ve learned a lot (with a little patience, leaning the rules of retirement investing wasn’t that difficult) AND I’ve since gotten out of debt and realized just how critical it is getting a jump on saving for the future. And the absolute best way to do that, in my opinion, is with a Roth IRA.
WHAT IS A ROTH IRA?
A Roth IRA is a type of individual retirement savings account with one extremely attractive tax benefit: Your contributions and interest earnings grow tax-free and, at retirement, withdrawals are 100% tax-free.
This benefit distinguishes the Roth IRA from the traditional IRA, in which contributions are tax deductible, but withdrawals are taxed at retirement time. If you can get money into a Roth IRA at an early age and let it grow for 25 or 30 years, you’ll earn a lot of money in interest tax-free!
But why is a Roth IRA better than a traditional IRA? Because, for two reasons, you’ll usually end up paying less taxes on a Roth:
- Many investors will be in a higher tax bracket in retirement than they are now, meaning it’s better to pay less taxes on the money you invest now rather than more taxes on money you take out later. (The exception to this rule might be a high-earner who plans to retire early and live very frugally for many years).
- Taxes probably aren’t going down. If anything, taxes will go up before we all retire, meaning it’s better (again) to pay the lower tax rate now instead of higher taxes later.
OTHER BENEFITS TO A ROTH IRA
Another reason Roth IRAs are great is because IRAs have a leg-up over the 401(k) plans you may have at work. Unlike 401(k)s, IRAs let you invest your money virtually anywhere: mutual funds, exchange-traded-funds, individual stocks, or even cash money market accounts. Just pick your favorite broker and you’re off.
When you make IRA contributions, your goal is to leave that money untouched until retirement so it can reap compound returns year after year. Another perk of the Roth IRA, however, is that you can withdraw your contributions at anytime, tax-free, and with no penalties (unlike traditional IRAs and 401(k) accounts). This allowance applies to your contributions only, not the interest you earn, which is subject to the same federal taxes and 10% penalties as withdrawals from traditional IRAs and 401(k) accounts.
One final perk is that you can use up to $10,000 in contributions (and earnings) tax-free and penalty-free from a Roth IRA to purchase your first home. The only requirement is that your IRA account must have been open for five years.
There are federally-imposed limits on how much you can contribute to an IRA each year—in 2012 the limit is $5,000 per year for everybody 50 and under.
|Under 50||50 and Older|
The other thing you’ll have to watch out for are Roth IRA income limits. Basically, if you earn above a certain amount, the IRS won’t let you contribute to a Roth. In 2012, single filers with a modified adjusted gross income (MAGI) more than $110,000 and married joint filers with a MAGI more than $173,000 are ineligible to put the full amount into a Roth IRA. Single filers who earn less than $125,000 but more than $110,000 and married joint filers making less than $183,000 but more than $173,000 can make partial contributions (not the entire $5,000).
|Filing Status||Full Contribution||Partial Contribution|
|Single||Up to $110,000||$110,000–$125,000|
|Married, Filing Jointly||Up to $173,000||$173,000–$183,000|
|Married, Filing Separately*||$0||$0-$10,000|
*Limits apply if the couple lived together for any part of the year.
HOW TO OPEN A ROTH IRA
Don’t let whatever the stock market is doing at the moment deter your decision to start a Roth IRA this year (in fact, smart investors often ignore the stock market). So if you don’t have a Roth IRA (or haven’t contributed to your account this year), do so now!
If you don’t already have an IRA account, I recommend any of the following online stock brokers. All have IRA accounts that are easy to open and all provide limitless investment opportunities for low fees.And don’t worry if you don’t know where to invest…just pick one or more exchange traded funds (ETFs) that follow one of the stock market’s averages like the Dow Jones Industrial Average or S&P 500. As your balances and investing savior faire develops you can tweak your asset allocation accordingly.