Episode 273: June 26, 2012
by Laura Adams
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This is the second episode in a 2-part guide to the Roth IRA. In the first episode I covered what a Roth IRA is, who can have one, and the rules for making withdrawals. Today, you’ll find out when you should opt for a Roth IRA, the types of investments a Roth is ideally suited for, and where to get one.
What Is a Roth IRA?
As you learned in part one, an IRA is a special account that helps you build a healthy nest egg by cutting your taxes.
Contributions you make to a Roth IRA are never tax deductible, which means they’re taxed before going into the account. However, your earnings grow completely tax free and then you can take withdrawals during retirement without owing a penny to Uncle Sam.
These rules are the opposite of a traditional IRA where contributions are tax deductible but you pay tax on both contributions and earnings when you take withdrawals in the future.
When Should You Get a Roth IRA?
Since a traditional and a Roth IRA both have fantastic advantages, you may have a hard time knowing which one to choose. Here are 5 situations when it makes sense to opt for the Roth:
1. When your income is low. If you’re earning less today than you believe you’ll earn in the future, then the Roth is probably your best choice. That’s because you’re in a relatively low tax bracket right now, compared to what it could be in the future.
Therefore, if your tax rate is low now, it’s cheaper to pay tax on Roth contributions than to pay tax on withdrawals from a traditional IRA in the future when your tax rate may be much higher.
2. When you’re young. If you’re just starting your career, not only is your income generally low, but you have decades to go before retirement. If your Roth IRA account value explodes over time, you’ll avoid paying tax on a heap of money.
For example, if you invested $400 a month for 40 years, that’s a total of $192,000 that you put away in your Roth IRA ($400 x 12 x 40 = $192,000). If you earned an average return of 7%, your account would be worth over $1 million dollars after 4 decades.
The difference between the account value and your contributions is massive—over $800,000 ($1 million - $192,000 = $808,000). And every penny of those investment gains would be exempt from tax because it’s in a Roth. If your average tax rate were 15%, that’s a tax savings of over $120,000 ($808,000 x 0.15 = $121,200)!
3. When you don’t need a tax deduction. The best part about a traditional IRA is getting a tax deduction in the current year. That can be a godsend when you don’t have any other tax deductions or credits to shrink a big tax bill.
But if you already have plenty of ways to trim your taxes—like mortgage interest, medical expenses, or tax credits—then making Roth IRA contributions would be an advantage.
4. When you participate in a retirement plan at work. If you (or your spouse) make contributions to a workplace retirement account—like a 401(k) or a 403(b)—and you earn over a certain amount, some of all of your traditional IRA contributions may not be tax deductible.
Related Content: Should You Contribute to Both a 401(k) and an IRA?
With a Roth IRA, on the other hand, there’s no limitation to maxing it out and contributing to a retirement plan at work in the same year.
Quick and dirty tip: If your employer offers to match contributions you make to a workplace retirement account, always contribute enough to max out the match before contributing to an IRA—otherwise you’re leaving money on the table.
5. When you want the option to withdraw funds before retirement. Since you pay tax upfront on Roth IRA contributions, you can withdraw them at any time without paying additional tax or penalties. That means you could easily use the money any way you like, such as to buy a home, pay for education, or start a business.
Of course, I don’t recommend withdrawing funds from a retirement account unless you already have a healthy nest egg somewhere else. And as you learned in part one, withdrawing earnings from a Roth IRA before the official retirement age of 59½ generally triggers income tax and a 10% early withdrawal penalty.
Best Investments to Own in a Roth IRA
You’ll get the most tax savings by bying investments that could potentially mushroom in value, such as growth stocks and funds.
Since the Roth offers tax-free account growth, you’ll get the most tax savings by owning investments that could potentially mushroom in value, such as growth stocks and funds.
Other smart choices are investments that pay dividends, like bonds, bond income funds, and dividend stocks. All of the investment growth and income that you hold in a Roth IRA will be tax-free when you decide to take withdrawals in retirement.
Where to Get a Roth IRA
If you’re ready to start taking advantage of tax-free account growth for retirement, you can open a Roth IRA through an investment advisor or at many different banks, mutual fund companies, or brokerages. Opening a Roth IRA is just as easy as opening a bank account. You complete an application and transfer funds to activate the account.
Look for a company that offers the kinds of investments that you want to make, like mutual funds, exchange-traded funds, or stocks. If you have no idea what investments are right for you, choose a company that offers free investment advice and gives you simple options, like our sponsor Betterment.com.
Go ahead and put your Roth IRA on auto-pilot by setting up recurring monthly deposits. In some cases, signing up for an automatic investing program will reduce or eliminate any minimum balance requirement—plus, it will help you build wealth for retirement even faster.
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