Ask the Dollar Diva By Dorothy Rosen • Bankrate.com

How to become a millionaire with a Roth IRA

Dear Dollar Diva,
How good is the Roth IRA, and how easy is it to acquire?
Greg

Dear Greg,
How good is the Roth IRA? It's not as good as winning the lottery or marrying a millionaire, but it's up there. The younger you are, the sweeter it is because you have more years to accumulate tax-free earnings. An illustration using a 30 year-old-taxpayer with $20,000 in his Roth IRA follows.

The Roth IRA is also very easy to acquire.

Tax-free earnings
Although you don't get a tax deduction for your Roth IRA contribution, all future qualified distributions will come to you tax-free; that includes your original contributions plus the income and appreciation that the investment earns over its lifetime.

Let's pretend 25-year-old John invests $3,000 in a Roth IRA every year for five years and the investment earns 10 percent a year. At the end of five years, his total account would be worth about $20,000 -- $15,000 in contributions and $5,000 in earnings and appreciation.

Let's pretend he never puts another dime in this account; the $20,000 just sits there generating income and appreciation at 10 percent a year. If he allows the IRA to grow until he's 72, John will be rewarded with $1,280,000 in tax-free dollars. The years between his twilight and sunset can be spent traveling around the world instead of clipping coupons. If he's already seen the world, he can pay for his grandkids' college educations or let the account keep growing, so his heirs will have something nice by which to remember him.

The Rule of 72
You can quickly calculate how big your nest egg will grow by using an approximation called The Rule of 72: Divide 72 by an interest rate and voila! That's how many years it takes to double your money. So if John's $20,000 earns 10 percent, 72 divided by 10 is about seven.

Here's how the account would grow from $20,000 to $1,280,000 using the Rule of 72:

A dollar will be worth a lot less in 2044 than it is today, you say. The Diva responds: It's going to take a lot more than 42 years to reduce a million and a quarter to chump change.

For more on the upside of the Roth IRA, read the Diva's "Roth conversions look good."

How much can you invest in a Roth IRA?
Most working folks can contribute up to $3,000 to a Roth IRA in 2002; if you're older than 50, it jumps to $3,500. Here are some of the rules and limits:

Age. There are no age limits; if you have taxable compensation (wages, bonuses, tips, self-employment income), you can contribute to a Roth IRA.

No paycheck, no Roth. You have to have taxable compensation of at least $3,000 to contribute $3,000 to an IRA; at least $3,500 to contribute $3,500.

Income limits. The ability to make Roth IRA contributions phases out for single taxpayers when their modified AGI is between $95,000 and $110,000; for married taxpayers filing jointly, the phase-out range is $150,000 and $160,000.

Time frame. You have until April 15, 2002 to open a Roth IRA account and make a contribution for 2001. The maximum contribution for 2001 is $2,000. Contributions for 2002 can be made anytime from Jan. 1, 2002 to April 15, 2003. But remember, sooner is better than later when it comes to accumulating tax-free earnings.

Low-income taxpayers invited to the feast. This is new for 2002. The IRS is giving tax credits to low-income workers (not students) for making contributions to retirement plans, such as Roth IRAs; Uncle Sam wants everyone to save for retirement. For more on this go to "Important Changes for 2002" on the IRS Web site.

For more information on traditional and Roth IRAs, read IRS Publication 590, Individual Retirement Arrangements (IRAs).

The downside of the Roth IRA
OK, the Roth IRA is not perfect; but what is? Here are some of the things you'll want to think about before you become a Roth IRA groupie:

• In most states, your traditional IRA and other tax-deferred retirement plans are creditor protected; no one can touch them but you. Not so with the Roth. In most states it gets put on the block if there's a judgment against you. If you think you might get sued, file for bankruptcy or dump your spouse, the Roth IRA may not be a good choice for you.
• There's always some uncertainty when you're dealing with Uncle Sam. Will he change his mind about the tax-free status of Roth IRA distributions in the future? Some folks pay tax on 85 percent of their Social Security payments; will that be the fate of the Roth IRA 30 years from now? Your guess is as good as anyone's.
• If you want to convert a traditional IRA to a Roth, beware of the minefields: You can be pushed into a higher tax bracket; if you're collecting Social Security, more of it will probably be taxed; and the addition to adjusted gross income may cause you to lose benefits such as education and child tax credits or deductions for student loans.

How easy is it to acquire?
A Roth IRA isn't an investment, per se. It's more like a label put on an investment to identify it as a retirement account. The actual investment can be in stocks, bonds, mutual funds, money market accounts, certificates of deposit or gold bullion. It cannot be in vintage wines, Mapplethorpe photos, rubies, stamps or other collectibles.

First, decide what you want to invest in. Then, find a financial institution to sell it to you. Fidelity, Janus, TIAA-CREF, T. Rowe Price and Vanguard will sell you no-load mutual funds with reasonable expense ratios; search the Web for more.

If your time horizon is long, investing in stocks or stock mutual funds is the way to go. Do your homework first: Start by reading the Diva's "Investment's magic formula: Allocation plus annual rebalancing." It will link you to other stories that will help you get started.

If you know nothing about investing but want to have your money in the market while you learn more about it, the Diva's "Mutual fund alphabet soup? That's a load" will introduce you to the S&P 500 index fund; that boring, no-brainer fund that makes investing simple and delivers market returns year after year. Like the market, some years are good, others are bad, but over the long haul you can expect a better return than you'd get with most other investments.

If your time horizon is short and you want to invest in certificates of deposit, shop around for the best deal. To compare what's out there, Bankrate.com's CD rate search engine gives up-to-the-minute rates. Once you find the one you like, call or visit the bank; a representative will be more than happy to help you fill out the Roth IRA application.

The lower tax rates go, the better the Roth IRA looks. Everyone knows what goes down must come up, so investing in the Roth with after-tax dollars when the tax rates are low and taking tax-free distributions in the future when rates may be higher sounds like a pretty good strategy to the Diva.

-- Posted: Jan. 17, 2002

DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting, from the Kellogg Graduate School at Northwestern University in Evanston, Ill. Rosen has more than 15 years of experience in the financial arena, serving in Illinois and Florida as a certified public accountant, financial consultant, expert witness and educator. She is owner of Dorothy Rosen, CPA, a public accounting firm that serves individuals and small businesses.