The ABCs of Roth IRAs
I've heard a lot about Roth IRAs, but
don't know how to go about opening one. Where do I start?
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.
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.
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
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.
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.
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
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. Indexfunds.com
can also help you choose the right index for your investment goals.
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.
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.