Investing 101: Roth IRA
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 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
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5 comments
Great to hear that the limit’s been increased! I’ve been doing this since when I became eligible to…18? I forget. At first I felt at a loss without the extra cash, but over time I just got used to the leftover I had coming to me every month, not only after bi-weekly Roth deductions, but also 401 (k) deductions.
Even if you take interest growth out of the equation, its still money saved which starts looking like a lot of money over time. I believe there are three things you can dip into the account for; education, catastrophic coverage, and first time mortgage.
I think its absolutely wonderful that you’re getting the word out there to people about savings. If and when social security become privatized, this is the exactly the kind of dissemination of information that will be necessary for people to start making sense out of saving.
Just because the country is in debt, doesn’t mean we have to jump on the bandwagon. Great post!
Hi Cameron,
very informative article. As I am not a USA citizen, I don’t really understand IRA and Roth IRA, but now I know better.
Thanks for sharing.
Oh, I also notice you have A Long Long Road on your blogroll. Thanks, I’m very honored. Please keep up the good work, even though your blog is new. It’ll take some time, but it’ll grow.
Hey Thanks for the comments on my site.
As for Roth IRA, there’s a huge advantage: No short term capital gains tax (as long as you don’t withdraw your earnings before you’re 60 years old). I’m a long term investor, but that’s huge for traders and momentum investors.
Also for Roth IRA, you can take out money before you’re 60 years old, but only what you’ve contributed.
Like you mentioned a Roth IRA should be taught to every kid in the country. It’s seriously the best retirement account you can ever have.
For instance if you’re 20 years old and start contributing the max amount every year, with 10% gain every year; when you turn 60 years old, the account will be worth $2,000,000 tax free.
What do you think about the Monetta Young Investor Fund?
Bob, I am unfamiliar with the Fund so my comments below are simply based on a quick glance at the fund so definitely do your own due diligence. I checked out their website and it seems like an decent idea from what I read…I like the idea of getting kids interested in investing. It looks like 1/2 of the holdings are in the S&P 500 index funds and the other half are in “kid” companies like Disney, Coke, etc. Since these are large, multinational companies I don’t think you’d be taking on too much risk.
The only thing I don’t like is the expense ratio of 1.44%. This is simply a personal preference of mine, but I refuse to pay more than 1% for a mutual fund simply because there are so many good options out there with low expense ratios from companies like Vanguard or American Funds. I’m a big fan of dollar-cost averaging into a low-cost index fund.
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