Due to my love for finance and my ability to throw out the random buzzwords like “asset allocation” and “diversification” to sound really smart, many of my friends have begun to come to me for investment advice. “Cameron,” they ask, “this investing stuff is just too complicated, I am (insert an age) and still haven’t invested in anything, I don’t even know where to start.” The first question I always ask is whether or not they have a Roth IRA? Judging by some of the responses I have received I think it’s time to explain what a Roth IRA really is and why if you are young (college, twenty-something) and you don’t have one, you are throwing piles of cash down the toilet.
IRA stands for Individual Retirement Account, basically a simple way of saving money for retirement — remember though, it is just an account, not an investment itself. With an IRA you can choose where you want to invest your money. Think of an IRA as a basket in which you can throw various kinds of investments. Most people choose to throw a mutual fund in their IRA which is why you will hear the terms getting thrown around and mixed-up most of the time. As long as you remember that an IRA is simply an account to place investments in, you’ll avoid a lot of confusion.
Traditional Vs. Roth – These are the two main types of IRAs. I will save you the trouble right now and tell you that if you are under the age of 50 and you don’t make six figures then Roth is the way for you to go. The main difference between traditional and Roth IRAs are how you are taxed. With a traditional IRA you get a tax break when you deposit the money in your account each year. This means if you make $50,000 of taxable income in a year and place $3,000 in your IRA you will only pay taxes on $47,000 that year. Your money will then grow and when you take the money out after age 59-1/2 you will then pay taxes on the money in your IRA. A Roth IRA is different because while you get no tax break up front, your money grows tax-free in your account and when you take it out come retirement time, YOU PAY NO TAXES, not even on the earnings. Another way of saying it, traditional IRAs are “tax-deferred” and Roth IRAs are “tax-exempt” savings. American Funds has a great comparison chart comparing the two types.
Some Rules to Know – First, being that it is a retirement account you will be heavily penalized if you take the money out early, meaning before age 59-1/2 (there are a few exceptions like a first-time home purchase). This means put money in your IRA that you won’t need in the near term.
Second, for you overachievers, the maximum contribution has just changed from $4,000 per year in 2007 to $5,000 per year in 2008.
Finally, to be eligible for a Roth IRA you must make less than $101,000 as a single filer or $159,000 as a joint filer in 2008. So, if you’re raking in some good money already and you exceed these limits you will only be able to invest in a traditional IRA, still not a bad thing.
How to Set Up a Roth IRA – First, remember that banks and investment companies want your money, so they’re going to make it as easy as possible for you to give it to them and if they don’t, shop somewhere else. All you need to set up your account is your W-2 form showing you have earned income. There are a few different places you can go to set up your Roth IRA: bank/credit union, mutual fund companies, or discount broker. The bank route would be for the ultra-conservative investor that wants to use CD’s or money market accounts as their investments (if you’re under the age of 50 this is probably too conservative).
Next would be opening it through a mutual fund company. My favorites include: Vanguard, American Funds, USAA (All of these links will take you to the page dealing with opening an account with the company). By going through a mutual fund company you can then purchase shares in one or multiple funds from the company and put them in your Roth IRA. This method also helps ensure greater diversity being that with a mutual fund you are automatically investing in hundreds of companies rather than just one or two, spreading out your risk substantially. Plus, many times the minimum investment is lower when opening a retirement account than it would be with a normal brokerage account. The final avenue would be using a discount brokerage service, similar concept as above.
Once you have opened your account the next step is setting up an automatic investment plan (takes out money from your paycheck and automatically puts in your investments) so you can harness the power of dollar cost averaging (DCA), an investment principle I wrote on earlier (here).
Once you have this set up your goal then becomes to “max out” your IRA each year, or getting as close as possible.
With our country’s social security system looking more and more shaky all the time and many businesses moving away from traditional pensions, taking control of your own retirement is becoming more necessary than ever before. Probably the biggest reason people put off retirement planning and investing is simply lack of knowledge. The financial education given in the primary and secondary school systems is abysmal and unless you actively seek out investment classes in college, one can go through many years of school without learning even the most basic investment principles. So, if that is you, start now. Don’t be afraid to ask questions. Remember that your future is no one’s responsibility, but your own. As a young person time is on your side and by starting now you can quite easily amass a large amount of money so you can do the things you want to do when you want to do them.
Other good articles on Roth IRAs:
- The World’s Easiest Guide to Understanding Retirement Accounts – Ramit Sethi (the man)
- Why You Need a Roth IRA – Kiplinger.com
- Roth IRAs: A better IRA for almost everyone – AmericanFunds.com