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. That limit was $5,000 for 2011 and also for 2012. That means if you act before April 17, you can invest $5,000 now to count for last year, giving you a solid start to your savings. And you have until next year's tax deadline to kick in your $5,000 for 2012.

Don't let the 2007-09 stock market meltdown scare you. Stocks historically do well over the long run, so a good place to start is with a well diversified mutual fund (see Start Investing in Three Simple Steps). But if you really don't like risk, the Roth lets you save in less-volatile investments, too, such as bonds or money-market accounts. The key is to find your comfort level and get started soon.

The tax advantage

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 $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 money. (Use this calculator to see how far your savings can take you. Enter "0" in the tax rate boxes to simulate the tax-exempt status of a Roth IRA.)

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% federal. That's more than one-fourth less money than if she'd gone with the Roth. If she owed state taxes on the money, too, she'd be down even more.

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 could contribute to a Roth would be $3,000.

It's also possible to make too much. You can contribute the full $5,000 in 2012 as long as your income falls below $110,000 if you're single, and $173,000 if you're married filing a joint tax return. The contribution limit is then phased out incrementally if you make between $110,000 and $125,000 (single) or $173,000 and $183,000 (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 qualify. If a 25-year-old saved $5,000 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 $481,000 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.

Bonus!

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 -- and you don't have to pay it back, like you do with a 401(k). 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.