Thursday, April 9, 2009

Brief overview of Roth IRAs

As you can tell, I am a big advocate of investing in the Roth IRA retirement vehicle. Recently, I was talking with a friend of mine and she mentioned that she should finally invest in one. However, until we were talking for a few minutes about Roth IRAs and when contributions could be made and how to invest, I did not realize she thought that all retirement vehicles meant that the money was tied up until at least 59.5 years of age. When she realized there were ways to withdraw money from the Roth IRA prior to retirement, she became greatly interested in what a Roth IRA could do for her.

Accounts like 401(k)s, 403(b)s and traditional IRA (individual retirement accounts) are tax-deferred. That means money iscontributed to the account before taxes are paid. That is why your end of the year tax statement, your W2, can show less money than your gross income because the money was put directly into the tax-deferred retirement account before taxes were calculated. Using tax-deferred accounts is one way to reduce your AIG, adjusted gross income, on which your federal and state taxes are based.

Roth IRAs are different; they are tax-exempt. While the money put into the account has already been taxed and does not decrease your taxable income, when withdrawn after retirement, no taxes are paid on the earnings. Furthermore, if you are not retirement age, you can withdraw your contributions without penalty. I believe the five-tax-year rule applies to contribution withdrawals, but this is one way to help fund schooling or a buying a first home. Leaving all your money in the Roth IRA account earns more dividends; however, this account type is flexible enough to give you options for pulling out the money if needed sooner than 59.5 years of age.

Roth IRAs are subject to contributions limits ($5,000 for 2009), income limits for single and married taxpayers, and do have penalties when contributions and earnings are taken out without following the allowed withdrawals terms. However, you can put in money for 2008 and 2009 years right now until April 15 to get one year closer to the five-tax-year "magic" number without waiting five calendar years. For more information on Roth IRAs, visit the Motley Fool. I have given a brief overview and the Web site has more details and examples to explain the various points.

Roth IRAs can be invested in anything from mutual funds to money market accounts and certificates of deposit. My Roth IRA is through T. Rowe Price and is composed of two index funds. My investment strategy is risky but I am hoping for greater rewards when I need the money. In the end, I contribute to both tax-deferred and tax-exempt retirement accounts. I put more than enough to get my employer's match for the 401(k)--I love free money!--and have made it a priority to fully fund my Roth IRA even if it takes me 14 months instead of the 12 calendar months. Consider the best strategy for you and weigh how each of these account types (tax-exempt and tax-deferred) will work for your retirement.


  1. That's a lot of knowledge! I worked at a day trading firm for many years, but being stuck in the administration, I learned very little about the markets and retirement options. I'm happy to say that TODAY I made my first contribution to a savings account, it's a start! As soon as the move is behind me, I'm going to do a lot more research into what retirement investments are for me, I may pick your brain a little bit in the near future!

  2. @Rain,

    Congratulations on your savings account. I feel accomplished having money in savings so I hope you feel good about it too. Just to warn you, my knowledge is based on US-specific accounts and I know Canadians have different options.

  3. It feels great to know I have some emergency money, finally! You're right, there are quite a lot of differences between the U.S. and Canadian tax/revenu/finance/money situation. I remember way back when reading "The Wealthy Barber" - it was a good "how to" kind of book for beginners, written by a Canadian, maybe I should read it again!