Well, by now you are aware that I really think a ROTH account be it an IRA or a 401(k) is one of the best retirement tools the government has given us. As more and more baby boomers retire meaning, there are more people entering Social Security and Medicare systems it will be more vital that future retirees have their savings in some form or another. With only about a quarter of Fortune 500 companies offering pensions and many ending their pensions this year or in the coming years it is going to be extra important for workers today to save in some manner. And the most popular saving techniques are a company 401(k) plans and IRA’s. So why a ROTH IRA? Here are a few reasons why I think a ROTH is the better way to go when it comes to an IRA.
First is the tax advantages of ROTH accounts. When you are younger, and earning less you probably are in a fairly low tax bracket, so there is really no reason to go with a Traditional IRA because of the tax deduction. It is not much to begin with and your taxes are low anyway so pay the tax on the $5,500 that you can contribute in 2014 unless you are already over 50 then you get an additional $1,000 in catch up contributions for a total of $6,500 a year. Now let’s say you are 25 and just out of college and do manage to contribute just $5,000 a year to a ROTH IRA for 40 years until you retire at age 65. If you earn a conservative 7.5% on that money, you will have over $1.2 million your account. And since the taxes have already been paid in the contributions that are tax-free money you will be taking out. Not a bad deal if you ask me as you only invested $200,000 over the 40 years and now you get $1 million tax-free.
Now to contribute to an ROTH account you need to meet some government requirements. First the money you contribute must be earned income. Meaning if you are in your teens and have a summer job and are thinking of investing for your retirement you can provided you contribute no more than you earned into the ROTH account. Meaning if you earned $4,500 in a year you could contribute a maximum of $4,500 to a ROTH IRA. Also, there are income limitations for contribution to ROTH IIRA accounts. If you are single and make over $114,000 or married and earn over $181,000 a year, you are not eligible to contribute to a ROTH IRA directly. But there is a way to get the money into a ROTH account with proper planning. What you need to do if you make over the income limitations is contribute to a non-deductible IRA and immediately convert it to a ROTH IRA. All you will have to do in this case is pay any taxes on any gains between the time you invested in the Traditional IRA and when you make the conversion to a ROTH IRA. To ensure you are doing this correctly and legally consult a qualified financial planner.
In a ROTH IRA, you can withdrawal the principal you have contributed. And if it is a converted IRA you may provide you have had the ROTH account for a minimum of five years. This means if you have had the account for 5 years on converted accounts, and made contributions of $20,000 you are allowed to take that principal out before age 59 ½ without penalty because taxes have already been paid on those funds. You are not allowed to take out any earning or profits in the account just the contributed principal otherwise you are looking at a 10% penalty. While I do not recommend taking money from any retirement account before you retire, this does provide options for someone who is in desperate need of additional money.
Some other benefits of a ROTH IRA are you can make a withdrawal for the purchase of your first home. Unlike just taking out the principal, you are allowed to withdrawal up to $10,000 in earnings as well without the 10% penalty being imposed. If you were married and each had a ROTH account, you would be able to take out the principal and a total of $20,000 in earnings without penalty. Just as above you must have had the ROTH account for a minimum of five years.
This also goes for paying for a child’s college education, so it gives you additional options when you are faced with saving for retirement and possible college expenses. Another tax advantaged way to save for college expenses is to open a state sponsored 529 plan in which you make contributions to the account and it grows tax deferred until your child or other family member incurs qualified college expenses which the 529 plan will pay for tax free. If you take the funds out of the 529 plan for reasons other than for education, you face taxes on the gains and a 10% penalty.
Again, the ROTH IRA has some excellent qualities besides being a tax-free investment. It allows the owner some freedom in making withdrawals under certain conditions allowing for people to purchase a first home or to fund a child’s college educations. But again, I stress saving for one’s retirement is vital in today’s world more than ever and I do not suggest or recommend using a ROTH IRA or any retirement account for any purpose other than your retirement. But if you have limited options it is always there in the event you do need it.
IRA’s can be invested in traditional things that most people associate with IRA’s such as equities and bonds. But you can also invest IRA funds in other things as well such as CD’s, real estate and precious metals. If you want to invest in equities, I suggest a discount on-line broker to minimize commissions on trades. For a mutual fund or many exchange traded funds, I would suggest investing through the actual company that runs the fund. For low-cost funds, I recommend Vanguard as they offer a wide selection of investment options, have low management fees, and allow you to change funds within a fund family at no cost. For a CD or money market account I would recommend a bank but if you want better rates look to on-line banks such as Ally or Capital One 360. If you want to invest in real estate, there are many complicated steps, and you must do it through a self-directed IRA normally with a designated trustee to manage your IRA. There are many such firms so you can Google self-directed IRA and a list of companies that do these IRA’s. And for precious metals you need to buy through a company that offers IRA’s and for a fee they will purchase your metals and store them for you until you sell them.
As you can see there are many advantages to a ROTH IRA, and there are many investing options. Their key to a wealthy retirement is to save as much as you can and start as early as you can. The compounding difference between someone who saves for 40 years and someone who only saves for 30 years is dramatic. Remember our example from earlier in the post? Someone who is 25 and saved for 40 years had $1.2 million at age 65. Now if you waited ten years and started saving at age 35 and only for the 30 years until you reach age 65 you would only have about $560,000 in the account. That is less than half! Now you can see the advantage of starting early.
If you have any questions or need any additional information feel free to contact me.