In this article, we’re going to dig a little deeper into the Roth IRA. Now that you know what a Roth IRA is, the next step is to determine if it’s right for you and, if so, how to make investments and contribution into it. Specifically, you’ll learn about the advantages and disadvantages of a Roth IRA, including tax implications.
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And when it comes to making investments and contributions to your Roth, you’ll want to have a strategy in mind because it’s not like having a regular savings account. But after reading all of the ins and outs, you should be confident going forward as to whether you should make a Roth IRA part of your investment portfolio.
Advantage and Disadvantages of Roth IRAs
As with everything in life, Roth IRAs have a good side and a not-so-good side. It is those factors that can help you to determine whether or not you will benefit from using Roth IRAs.
|Withdrawing money from a Roth IRA is tax-free as long as the account is at least 5 years old, and you don’t touch the money until you have reached the age of 59 ½ years.||Contributions to a Roth IRA are not tax deductible, so your current tax return would not benefit from investing the funds, like you would with 401(k) contributions, for example.|
|You will not be required to withdraw funds when you reach a certain age. So the account can be allowed to continue growing without being taxed for as long as you want, and can even be passed on to your heirs without taxes||Contributions to Roth IRAs don’t reduce your Adjusted Gross Income, so you may not qualify for other tax breaks that might apply if you were reporting a lower income.|
|You can continue to contribute to your Roth IRA, even after the age of 70 ½, which isn’t possible with Traditional IRA’s, for example.||If you don’t live to reach retirement age, then you won’t experience any benefits of a Roth IRA, you will have only paid the taxes in advance for your heirs.|
|Roth IRA contributions can be made even if you are contributing to other forms of retirement plans.||There are income limitations to Roth IRA contributions, which could either cap the amount you can contribute, or ban it altogether.|
|Spouses and beneficiaries of Roth IRA account holders who have died can combine the funds that they have inherited with their own and will not experience additional taxes or penalties.||There is a risk that Congress could alter the taxation rules in the future so that Roth IRA withdrawals may not always be tax-free.|
|You can withdraw your cash contributions from the account anytime without a problem, but not the earnings on investments.||You can only contribute up to $5,500 for 2013 vs $17,000 for a 401(k). (Note: The amounts tend to increase by $500 per year.)|
So there you have an objective look at the pluses and minuses of a Roth. But in my opinion, the good stuff definitely exceeds any possible bad points. And remember, you can still invest in your 401(k) and other plans to get favorable tax treatment. This is just another smart way to diversify your portfolio.
There are lots of financial institutions that will help you open a Roth IRA. These include banks, credit unions, mutual fund companies, brokerage firms, and more. I have a Roth through a fairly complicated set up that involves a wide range of investments. But if I was just starting out and wanted to keep things simple, I would probably open a Roth IRA with a company like Etrade.com.
The reason I would establish one with ETrade is because you get access to all kinds of investments. You can direct your contributions to stocks, bonds, options, 8000+ mutual funds, and more. You’ll also have more flexibility with them than going with a company such as Fidelity Investments, which doesn’t offer the mutual fund products of their competitors. But ETrade makes it easy for you to buy into Fidelity’s products and those offered by many other companies. Here’s a link to their database of funds
On top of that, their fees seem to be quite reasonable.
What Investments Should You Choose?
As mentioned above, there are a bunch of investment options that you can place in your Roth IRA bucket. It’s tough to know what to do. However, I have two strategic suggestions for you.
Only put in what you can leave in – A Roth IRA is intended to be a long-term plan that will provide you with income in your retirement years. That’s why there is an awesome rule that says if you don’t touch the money until after age 59.5, then you won’t pay any more taxes on it, ever.
So only contribute amounts that you don’t think you’ll need any time in the near future for a home, car, or any other reason. Even better, just have a fixed amount automatically deducted from your checking account every month. This way it will feel like you’re just paying a regular bill. It’s doesn’t matter if it’s $25. Just do it.
Avoid any investments you don’t understand – Investing through your Roth IRA should not be viewed as playing with funny money, house money, etc. I would avoid activities such as investing in things like high risk individual stocks and commodities.
Personally, I’ve tended to primarily fill my Roth IRA bucket with mutual funds. Think of a mutual fund as a basket of stocks from a bunch of companies. So when you invest in the mutual fund, you’re getting a slice of the combined bunch. You own a little piece of every company in the fund.
This is how mutual fund companies reduce risk so that you don’t lose your shirt overnight, which could happen if you invested in a single speculative stock. There are all kinds of mutual funds. They can be categorized by industry, location, company size, growth potential, and more.
The most famous service for rating the quality and performance of mutual funds is Morningstar.com. There’s no charge to review the ratings, but you will have to create an account on their web site. The only downside is that this is large web site that covers a wide range of investment vehicles, so it can be a bit intimidating if you’re new to this sort of thing.
Alternatively, you could perform a web search using the phrase like “top mutual funds 2013”. In the results, you’ll discover that popular magazines such as Money, Kiplinger, and others will share their short list of the best funds. What you’re looking for are funds that have shown a nice positive return on their investments, at least over the last three to five years.
If you find a mutual fund that you like, be sure that the financial institution that manages your Roth can get you into that fund. For ETrade you can call them or search quickly through their database of thousands of funds to see if your choice is listed. They’ll even give you the Morningstar rating.
Finally, if this stuff totally confuses you, contact the institution and ask to speak with a mutual fund advisor. Their job is to guide and assist you, and answer questions. But the bottom-line is to take action.
How Much To Contribute
You know the maximum annual contribution amount for a Roth IRA. So the issue is how much money should be directed to it when compared to other investment options such as a 401k.
A key thing to keep in mind is that you’ll be putting away money that you don’t want to touch for years. With that out of way, I would suggest that you contribute to your company sponsored retirement plan first.
Most retirement plans (e.g., 401k, 403b, etc.) include a benefit where your employer will match your contribution amount up to a certain level. The matching is free money for you. So, at a minimum, you should make sure that you take full advantage of this benefit. Then you can direct other savings into your Roth Account.
Finally, you should save money on a consistent basis, such as bi-weekly or monthly, as opposed to once a year, for example. This will allow you to take advantage of a strategy called “Dollar Cost Averaging”.
Since stock prices fluctuate up and down throughout the year, you don’t want to be in a position where you sink a big lump sum of money into a stock-based investment (e.g., mutual fund) when prices are at their highest. That would translate into you getting less for your money, right? For example, if you have $100 to invest and the price of a stock is $20, you’ll get 5 shares. But if the stock price were to drop to $10, your $100 would buy you 10 shares.
Of course, it would be nice if we knew when a stock price was going to be low, but the stock market is unpredictable and you don’t want to play the guessing game.
Dollar Cost Averaging means that you’ll be allocating a set amount of money to the investment instrument (e.g., mutual fund) once or twice each month regardless of what’s happening in the stock market. As a result, you’ll sometimes be buying shares when stock prices are high and sometimes when prices are low. This is the averaging or smoothing effect, and will relieve you from the stress of watching the turmoil in stock market on a daily basis.
- Open a Roth IRA and contribute to it consistently, preferably using automatic payments.
- Fill your Roth IRA bucket only with investments that you feel comfortable buying into.
In conclusion, the overall emphasis of this Yellow Wealth Belt mini-course, which is closely tied to the White Wealth Belt course, is to continue to help and encourage you to reduce debt and expenses. So implement the action steps for raising your FICO credit score and follow the 8-step credit dispute strategy if your credit file contains errors or outdated information.
When spending money, limit it to the things you need rather than the niceties you want. And when there’s light at the end of the debt tunnel, establish a Roth IRA and start saving more. Do these things and you’ll quickly find yourself at the next wealth belt level of GREEN in no time at all.
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