Why You Need a Roth IRA
One of the smartest money moves a young person can make is to invest in a Roth IRA — and setting one up is easy.
See Also: 8 Reasons You Need a Roth IRA Now
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 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 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. The limit is $5,500 for 2013 and 2014. That means you can invest up to $5,500 to count for tax year 2013 if you act before April 15, 2014, giving you a solid start to your savings. Although you have until next year’s tax deadline to kick in your $5,500 for 2014, the sooner your money is in the tax shelter, the sooner the tax-free earnings begin to accrue.
For those just starting out, the power of this tax shelter may seem a tad obscure, but it can really pay off big. If a 25-year-old contributes $5,000 each year until she retires and makes an average annual return of 8% on her investment, she'll have $1.4 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 withdraw the earnings.
If that same 25-year-old invested that same $5,000 a year in a taxable account earning the same 8% return, she'd only have about $1 million after 40 years if her earnings were taxed at 15% each year. That's more than one-fourth less money than if she'd gone with the Roth. If state taxes bit into the earnings each year, too, she'd be down even more.
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 could contribute to a Roth would be $3,000.
It's also possible to make too much. You can contribute the full $5,500 in 2014 as long as your income falls below $114,000 if you're single, and $181,000 if you're married filing a joint tax return. The contribution limit is then phased out incrementally if you make between $114,000 and $129,000 (single) or $181,000 and $191,000 (married-joint). (See IRS Publication 590 for more on calculating your contribution.) Those income limits go up each year, but if sometime in the future your income breaks through the ceiling, don’t worry. You won’t have to liquidate your Roth; you’ll just be prevented from making additional contributions.
If the savings power, flexibility and tax-free status aren't enough to persuade you of the Roth's virtues, Uncle Sam throws in a few extra perks, making the Roth an indispensable tool in a young adult's financial life.
You can take money out in a pinch. Although the purpose of a Roth is to save for retirement, and your money can grow only if you leave it in the account, you can withdraw your contributions at any time, tax free and without penalty. Of course, it's best to leave your money in the account so you can earn more money, and you really should have a separate emergency savings account on standby, but it's nice to know the Roth is there for you if you need it.
Notice we said you can take out your contributions at any time — not your earnings. If you withdraw any of your earnings before age 59½, you'll trigger a tax bill on the money, plus you'll have to pay a 10% penalty. Ouch. On the bright side, the way the IRS looks at things, the first money that comes out of a Roth is your contributions. So it’s tax and penalty free. Only after you’ve drained the account of every penny you have contributed do you begin to dip into earnings. . . and have to worry about taxes and penalties. And, there are even exceptions to that rule. Read on.