Today’s post is part of a 100+ blog effort to educate the world about Roth IRA’s. Jeff Rose of Good Financial Cents recently gave a talk about financial basics at his alma mater and was amazed to find that not a single one of the students who attended knew what a Roth IRA was. And so the Roth IRA Movement was born.
In case you are like one of Jeff’s students and don’t actually know what a Roth IRA is, I’ll start with a brief introduction. An IRA is the Irish Republican Army. It’s also an Individual Retirement Account. I knew the former definition before the latter, which made me very confused as a teen when my grandfather talked about getting money from his IRA. An IRA is a retirement account in which you can invest money in stocks and bonds for your nest egg. Like a 401(k), but not through your employer.
Traditionally (i.e. a Traditional IRA), the money you invest is tax-deferred. This means that you can deduct the money you invest in your IRA from your income when you file your taxes. The taxes you pay on this money are deferred until you withdraw the money.
In 1997, Senator William Roth introduced a significant change to tax law by creating an option to pay taxes on your IRA investments when you make them now instead of deferring them until when you use the money in the future.
This has the significant advantage in that there will be a lot more money in your IRA when you retire then just what you put into it. This investment income is now tax-free.
Why I love my Roth IRA:
I opened my IRA account in 2008. I figured that the stock market was just about rock-bottom and this would be the best time ever to start saving for my retirement. I guess I was right. Even with the rough ride that the second half of 2011 brought, I’m up almost 30% in little more than 3 years. And I’m a rather conservative investor.
It was at the time of opening my IRA when I was first introduced to the concept of a Roth. I researched it a bit and jumped right in. At the time, I was 27, had $500 to invest, and was in the 10% tax bracket. While I can’t say for certain what my future income will be, it’s unlikely that I will be in a lower tax bracket when I retire. Because the only thing lower than 10% is 0% and I’ll be in a lot of trouble indeed if I have so little money when I retire to qualify for that.
Based on my investing style, I figure I’ll average about a 5% return long-term. Using the rule of 72, this money will double three times before I am ready to retire. My modest $500 becomes $4000. Assume for a minute that I’m still (or again) in the 10% bracket when I retire. If I deferred taxes on that $500 investment, I would be paying $400 in taxes. 80% of my original investment. By electing to invest in a Roth IRA, I paid my taxes on it when I earned the money in 2008, and paid just $50 in taxes. $400 vs. $50. It was a pretty easy decision.
Another reason to love the Roth IRA:
Do you have a 401(k) from your employer? I don’t; they discontinued the company match before I started. But if you do, you already have a tax-deferred retirement account. Why not diversify and defer tax on some of your retirement savings and pay taxes now on the rest of it? That way, you are hedging against your personal tax rates going in either direction.
But wait, there’s more!
If you make more than $66,000 (or $110,000 if married filing jointly), the IRA won’t let you invest in a tax-deferred 401(k) and IRA. You have to go Roth for one of them (and not many employers offer a Roth 401(k)). Of course, there are income limits for being able to invest in a Roth account ($105,000 or $169,000 filing jointly), but if you fall in that range, Roth opens up an investing opportunity for additional retirement savings.