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The Roth IRA: A Saver’s Best Friend


Ready to start investing on your own? Then a Roth IRA is the first place to look.

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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 percent 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 percent 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.

ROTH IRA CONTRIBUTION LIMITS

There are federally-imposed limits on how much you can contribute to an IRA each year—in 2014 the limit is $5,500 per year for everybody 50 and under.

Under 50 50 and Older
$5,500 $6,500

ROTH IRA INCOME LIMITS

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 2014, single filers with a modified adjusted gross income (MAGI) more than $114,000 and married joint filers with a MAGI more than $181,000 are ineligible to put the full amount into a Roth IRA. Single filers who earn less than $129,000 but more than $114,000 and married joint filers making less than $191,000 but more than $181,000 can make partial contributions (not the entire $5,500).

Filing Status Full Contribution Partial Contribution
Single Up to $129,000 $114,000–$128,999
Married, Filing Jointly Up to $191,000 $181,000–$190,999
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 how to get started investing: 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. Look here for more IRA investment options. As your balances and investing savoir-faire develops you can tweak your asset allocation accordingly.

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. OK, so ever since the first day that I could, I’ve been participating in a 401k. When I left my first job about 1.5 years ago, I left my 401K with the original brokerage account (Charles Schwab). Now, with my new company, I contribute to a 401K at Fidelity. At this point, I can either:

    A. Roll over the Chuck Schwab 401K into a traditional IRA at Fidelity
    B. Roll over Chuck Scwab 401K into a Roth at Fidelity
    C. Keep 401K as is and continue letting it grow with the market (it’s allocated almost entirely in stocks and funds).

    Any thoughts?

  2. Rolling the old 401(k) into an IRA will diversify your portfolio, by allowing you the freedom of greater investment options of the IRA, not limited by your former company’s selected plan funds. You will also be able to make further contributions to the account.

    Whether or not you decide to make that rollover into a traditional or Roth IRA is totally up to you. I recommend having both ultimately, and maybe even at different brokerages.

    Keeping the 401(k) can be limiting and risky. It is limiting because you cannot make further contributions to the account since you have left your former employer. It is risky because if your employer decides to close their plan with the brokerage (they go out of business, for example) your balance may be sent to you in a lump sum payment, at their discretion, causing you the hassle of the penalties and taxes. Save yourself the hassle of scrambling to deal with that and make the change of your own accord, as you will be more informed if you plan ahead.

  3. I know nothing about stocks or mutual funds. What I would like to do is contribute 200 bucks a month into some kind of interest accruing account so 30 years down the road when im around 55 I have some money saved up. I dont like to gamble I just want to slowly accrue wealth, should i do a roth ira or some other kind of account.

  4. What about Roth 401(k)’s? Do you know if they have any income caps? I know the contribution limit is higher for sure – following a traditional 401(k).

    Would you also be able to invest in your choice of mutual funds instead of 10 or so preselected by your employer if you were to get them from a firm outside of your company (i.e. T. Rowe Price, Vanguard, etc)?

    • David Weliver says:

      Roth 401(k)s are gaining popularity among employers and employees, which is great. They offer the same tax benefit as a Roth IRA but with higher contribution maximums and NO income limit. If your employer offers a 401k plan, you can contribute no matter how much you make.

      In 2011, the contribution max is $16,500 for everybody 50 and under. (If you’re over 50 you can make an addition $5,500 catch up contributions).

      The downside to any 401(k) is you usually must invest in a small number of funds offered by your employer’s 401(k) plan provider. With an IRA, you can invest in anything you want.

  5. David,

    I very much enjoy your website, and despite this being an older post, I’m looking seriously into the Roth IRA at the moment. I currently earn below the income limit of 105,000, which would allow me to contribute. What I’m struggling to find, however, is information as to what happens once you reach the income limit? My current belief is that you simply cannot contribute any further to the account. Is this real? Are there better strategies out there for higher earnings?

    Regards,
    Carson Boddicker

    • David Weliver says:

      Good question Carson. Once you hit the limit, you’re right, you cannot contribute money to a Roth IRA. There is a phase out…so if you make between X and X you can contribute some (but less than $5,000).

      Higher earners can look to their employers’ 401(k) or similar plan. More and more companies are offering a Roth 401(k) option. There are no income limits on 401s, and you can put in up to $16,500 annually.

      If you’re self employed, you have a couple of options. You can contribute up to 25% of your annual profit and that contribution reduces your taxable income. There is no Roth option with a SEP IRA however.

      The other option if you are self employed with no employees is a solo 401(k), which may allow Roth contributions and has higher contribution limits ($16,500 of your salary and up to 25% of your profit). Here’s some more info from Fidelity:

      https://www.fidelity.com/retirement/small-business/self-employed-401k

      (Not necessarily an endorsement of Fidelity but a quick link I found with some more info). As for figuring out which one is right for you when you hit that income level, it’s probably a more sophisticated analysis that I can do in a blog comment and a good conversation to have with a tax advisor or financial planner. Good luck.

  6. So if I am married but filing seperately I am not allowed to contribute? Although I am well under then income limit.

  7. Hi,

    I am relatively young (26 y/o) and am trying to learn about all of my retirement options. The Roth IRA sounds like a great idea and is something that I want to start putting some of my savings in. I make a bit over 120K (but my annual income is under 125K) a year and am single, do you know what my contribution limit is?

    Thanks so much!

  8. With the new year just rolled in, I’m wondering whether I should contribute to my Roth IRA account in annuities so that I gradually max out my 5500 limit, or max out the account up front so that I have 5500 in my Roth IRA on day 1 (or at some other early dates in the calendar). I suppose it wouldn’t make any difference on the long run, but suppose I’d like to practice trading semi-actively, it’d be more advantageous with more asset in the account early on, right?

    I just started working last year, and have been buying ETFs only. Does it make sense to use the IRA account for active trading?

    I fell in love your blog David after I did the search “how much should I contribute to my 401k” on Google, and I hope you and your family will have a wonderful year in 2013!