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The ABCs of Roth IRAs

Dr. Don TaylorDear Dr. Don,
I've heard a lot about Roth IRAs, but don't know how to go about opening one. Where do I start?
Gail Goal

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Dear Gail,
Roth IRA's are tax-advantaged retirement accounts.

Unlike traditional IRAs where you make contributions with pretax dollars and then pay income taxes on the qualified distributions, with a Roth IRA you make contributions with after-tax dollars, and it's the qualified distributions out of the account that are tax-free.

You can also convert a traditional IRA into a Roth IRA by paying income taxes on the amount transferred. Roth IRAs are a good choice if you expect to be in a higher tax bracket when you retire than you are in today.

Just do it
People get nervous about making the right decision on how to invest the money and where they should open an account. But the important thing is to get started. It's easier to recover from a mistake about where or how the money is invested than it is to recover from the missed opportunity to save for your retirement.

Decide how you want to invest the money first. The three basic choices for financial investments in a Roth IRA account are stocks, bonds, or cash (money market). But you shouldn't look at this investment independent of your other investments. It's all your money, so consider the overall portfolio implications when investing in the Roth IRA.

For example, long-term capital gains are taxed as income coming out of a taxed-deferred retirement account (traditional IRA), at your capital gains rate in a taxable account, but will be tax-free as qualified distributions out of a Roth IRA account.

Short-term capital gains are taxed as income in both your traditional IRA and taxable account but grow tax-free in your Roth IRA account. Put the two together and it's easy to see why it's popular to invest Roth IRA money in the stock market.

Don't have a portfolio to consider? Remember to count your checking account and any CDs, savings bonds and real estate investments before you classify the Roth IRA as your only investment. If the house and the checking account are your only other investments, then that also points to the stock market as a good place for the Roth IRA investment.

Where to put the money
You've got three basic choices in deciding where to open a Roth IRA account. You can open it at a financial institution, a brokerage firm or directly with a mutual fund.

When you're just starting out, the annual expenses and fees surrounding the account can dwarf any investment returns, so it's important to consider these expenses. If you're putting $2,000 to work in 2001, and you pay a $30 account maintenance fee, and the investments have a 2-percent annual-expense ratio, then you have to earn 3.5 percent on your money to break even for the year. Buy a mutual fund with a 5.5-percent sales load, and it'll be even harder to break even.

My recommendation is for you to find a "no-load" family of mutual funds and start out with either a stock index fund, an indexed bond fund or a hybrid fund. (A hybrid fund invests in both stocks and bonds.)

Contact the mutual fund directly and open an account. Morningstar has a fund selector that will help you narrow down the number of choices. can also help you choose the right index for your investment goals.

The Economic Growth and Tax Relief Reconciliation Act of 2001 has increased the amount you can contribute starting in the 2002 tax year to $3,000 from $2,000. If you are married and file joint returns these limits are doubled.

There is also a provision for investors age 50 and over to contribute up to $500 above the standard contribution limit starting in 2002. You'll have to meet adjusted gross income standards and earned income standards to be eligible to make these contributions, but by funding in both the 2001 and 2002 tax years you'll get a jump-start on retirement savings.

-- Posted: Nov. 29, 2001




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