Why You Need a Roth IRA

2006-06-23

One of the smartest money moves a young person can make is to invest in a Roth IRA. 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 it 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 -- April 17 this year -- 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 -- currently up to $4,000 annually. That means you can invest $4,000 right now for 2005 and stash another four grand throughout 2006, giving you a solid start to your savings. The contribution limit rises to $5,000 in 2008.

The idea of saving on your taxes may seem a tad obscure, but it really can pay off big. If a 25-year-old contributes $4,000 each year until she retires and makes an average annual return of 8% on her investment, she'll have more than $1.1 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 cash out.

If that same 25-year-old invested that same $4,000 a year in a regular taxable account earning the same 8% return, she'd only have about $802,000 after 40 years if her earnings were taxed at 15%. That's more than one-fourth less money than if she'd gone with the Roth.

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 can contribute to a Roth is $3,000.

It's also possible to make too much. You can contribute the full $4,000 as long as your income falls below $95,000 if you're single, and $150,000 if you're married filing a joint tax return. The contribution limit is then phased out incrementally if you make between $95,000 and $110,000 (single) or $150,000 and $160,000 (married-joint). (See IRS Publication 590 for more on calculating your contribution.) Make more than those upper limits, and you don't have to cash out the account -- you simply cannot contribute any more money to a Roth IRA.

If you expect to exceed the Roth income limits at some point during your career, you should open a Roth now while you're young and your salary is low enough to get in. If a 25-year-old saved $4,000 a year for only five years, then didn't contribute another dime for the next 35 years because his income was too high, that money would continue to grow -- to nearly $385,000 by the time he turned 65. That alone certainly won't be enough to retire on, but it'll be a nice tax-free bonus to his other retirement savings.

Read the Roth IRA article here

Related Articles:
» The ABCs of the Roth 401(k)
» Roth IRA: What it is and how it works
» Benefits of opening an IRA

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