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Starting Out


Why You Need a Roth IRA

Kevin McCormally

With this indispensable savings tool, your money grows tax-free, you can invest in almost anything and you get several cool perks.



One of the smartest money moves a young person can make is to invest in a Roth IRA — and setting one up is easy.

See Also: 8 Reasons You Need a Roth IRA Now

Follow the rules, and any money you put into one of these retirement-savings accounts grows absolutely tax free: You won't owe Uncle Sam a dime as you let your savings accumulate, or when you cash out in retirement. Plus, an IRA is more flexible than a 401(k) and other retirement plans because you can invest it in almost whatever you want, from stocks and mutual funds to bonds and real estate.

If you haven't yet opened this gift from Uncle Sam, do it now. You have until your tax return deadline to set up and make contributions for the previous tax year. The government sets a limit on how much you can contribute to a Roth. The limit is $5,500 for 2013 and 2014. That means you can invest up to $5,500 to count for tax year 2013 if you act before April 15, 2014, giving you a solid start to your savings. Although you have until next year’s tax deadline to kick in your $5,500 for 2014, the sooner your money is in the tax shelter, the sooner the tax-free earnings begin to accrue.

Tax Advantages

For those just starting out, the power of this tax shelter may seem a tad obscure, but it can really pay off big. If a 25-year-old contributes $5,000 each year until she retires and makes an average annual return of 8% on her investment, she'll have $1.4 million saved by the time she retires at age 65. And the money is all hers — she won't have to give the IRS a cent of it if she waits until retirement to withdraw the earnings.

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If that same 25-year-old invested that same $5,000 a year in a taxable account earning the same 8% return, she'd only have about $1 million after 40 years if her earnings were taxed at 15% each year. That's more than one-fourth less money than if she'd gone with the Roth. If state taxes bit into the earnings each year, too, she'd be down even more.

Roth Rules

As with any government gift, the Roth IRA comes with a few strings attached. First, you can contribute to a Roth only if you have earned income from a job. Say you're in school, you're not working and you have a little extra money left over from your student loan or your parents gave you money. You cannot put it in a Roth. Also, you cannot save more than you made. So if you worked a summer job and made only $3,000, the most you could contribute to a Roth would be $3,000.

It's also possible to make too much. You can contribute the full $5,500 in 2014 as long as your income falls below $114,000 if you're single, and $181,000 if you're married filing a joint tax return. The contribution limit is then phased out incrementally if you make between $114,000 and $129,000 (single) or $181,000 and $191,000 (married-joint). (See IRS Publication 590 for more on calculating your contribution.) Those income limits go up each year, but if sometime in the future your income breaks through the ceiling, don’t worry. You won’t have to liquidate your Roth; you’ll just be prevented from making additional contributions.

Bonus!

If the savings power, flexibility and tax-free status aren't enough to persuade you of the Roth's virtues, Uncle Sam throws in a few extra perks, making the Roth an indispensable tool in a young adult's financial life.

You can take money out in a pinch. Although the purpose of a Roth is to save for retirement, and your money can grow only if you leave it in the account, you can withdraw your contributions at any time, tax free and without penalty. Of course, it's best to leave your money in the account so you can earn more money, and you really should have a separate emergency savings account on standby, but it's nice to know the Roth is there for you if you need it.

Notice we said you can take out your contributions at any time — not your earnings. If you withdraw any of your earnings before age 59½, you'll trigger a tax bill on the money, plus you'll have to pay a 10% penalty. Ouch. On the bright side, the way the IRS looks at things, the first money that comes out of a Roth is your contributions. So it’s tax and penalty free. Only after you’ve drained the account of every penny you have contributed do you begin to dip into earnings. . . and have to worry about taxes and penalties. And, there are even exceptions to that rule. Read on.



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Starting Out


Why You Need a Roth IRA

Kevin McCormally

With this indispensable savings tool, your money grows tax-free, you can invest in almost anything and you get several cool perks.



You can tap your Roth to buy your first home. As noted, you can always withdraw contributions tax- and penalty-free for any purpose. And, if you tap your Roth for a first-home purchase, in addition to using your contributions for the down payment, you can also withdraw up to $10,000 of earnings tax- and penalty-free if the account has been open for at least five years. Even if you fail the five-year test, the withdrawal will still be penalty-free, but you will have to pay tax on the withdrawn earnings. That $10,000 limit is per person, so couples could withdraw up to $20,000 of earnings if they each have a Roth.

If you don't meet the five-year test for tax-free earnings, you still can take out your earnings for your home purchase, but you'll have to pay taxes on the amount of earnings you withdraw. You won't have to pay the 10% early-withdrawal penalty, though.

You can use it to save for Junior's education. Many new parents don't know whether to save for retirement or the baby's college tuition. Hands down, retirement wins. There are lots of ways to borrow to finance a college deduction; for retirement, not so much. But starting a Roth is a great way to cover both bases, just in case. Focus on your retirement now, saving as much into a Roth as you can. And as your finances allow, consider opening a specific college-savings account for the new baby — say, a Coverdell or 529 plan. Then, when the day comes for Junior to head off to school, you can assess whether you can afford to — or need to — sacrifice some of your retirement dollars to make it happen.

You can, of course, take out your contributions at any time to help pay the bill. If you dip into earnings before age 59 1/2, you'll owe taxes (and before the account has been open for five years) — but you don't have to pay the 10% early-withdrawal penalty if you use the money for college. The Roth shouldn't be used as the sole savings vehicle for higher education, but it's nice to know you can use it if you need it.

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How to Open a Roth IRA

When you're just starting to invest, the Roth should be your first stop — even before you open a regular, taxable account, or contribute to a workplace retirement-savings plan. The only exception is if your employer offers a match on your 401(k) contributions. That's free money you don't want to pass up. In that case, contribute enough to win the match, then send any extra money into a Roth IRA. (Yes, you can invest in both a Roth and a workplace retirement plan.)

You can invest your Roth IRA in almost anything — stocks, bonds, mutual funds, CDs or even real estate. It's easy to open an account. If you want to invest in stocks, go with a discount broker. For mutual funds, go with a fund company. For CDs or money-market accounts, you can go through your bank.

Because you're young and have a long way to retirement, you'll want to invest in the stock market to get the highest returns over time. Rookie investors should stick to mutual funds that invest in stocks. They're easy to understand, you leave the stock-picking to the pros, and they make it easy to spread your risk around several stocks or bonds without putting all your eggs in one basket.

Most mutual fund companies even lower their minimum investment requirements when you open an IRA. T. Rowe Price, for example, requires $2,500 to invest in a taxable account, but IRA investors need only $1,000 to get started.

Use our Mutual Fund Finder to search for funds that have low investment minimums and that meet your other criteria. Stick to no-load funds with low expense ratios (the average expense ratio for stock funds is about 1.3%).

Many fund companies will let you open an account and make contributions online. Make sure you designate what year the contributions are for.

Not sure where to find the money to fund your account? Consider investing your tax refund. For the 2012 tax-filing season, the average check totaled nearly $3,000. That cash would make a great start to your Roth.

Another way to fund your account is to put it on autopilot. Most banks and brokers will allow you to set up an automatic investment plan taking the money directly out of your bank account and putting it into your Roth. It's much easier to find the cash when it's considered already gone than if you have to make a physical effort to write the check each month.

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