The Roth IRA: In Terms You’ll Understand
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An IRA (individual retirement account), not just the Roth IRA, is a mysterious creature to most young adults. We hear “retirement” and immediately think of an old man and woman sitting on rocking chairs on the front porch of their cozy home. What twenty-something-year-old wants that image in their heads when they’ve still got plenty of time to have fun and get wasted?
Avoiding the thought of the unforeseeable future is what deters most young adults from thinking about IRAs – plus they sound so confusing to understand that they don’t bother with it. After repeatedly letting friends know that I have a Roth IRA, they shoot awkward faces and ask me what it is.
The Roth IRA in a Nutshell
IRAs, whether it is a Traditional IRA or Roth IRA, is simply an account that you use to hold certain investments that often include stocks, options, ETFs, mutual funds, bonds, money market funds, U.S. Treasury securities, and certificates of deposit. So basically, it is a place where you put money with the hopes of it becoming more a lot more money.
Think of an IRA as your wallet. You have the choice of putting cash, credit cards, debit card, membership cards, a library card, receipts, identification, and the handy BandAid in it. It is nothing more than a place to put things.
The functions of an IRA sound very similar to that of typical brokerage accounts but there are key differences that make them “retirement” accounts rather than any other investment account. The Roth IRA has been a popular investment vehicle lately so I’ll break down the key points into easily consumable information that will hopefully encourage other young adults to start establishing their nest egg.
Funding Your Roth
You cannot just put $100,000 in a Roth IRA and start buying shares of Google, Apple, and Coca Cola or invest in the top 5 funds highlighted in a Kiplinger magazine. How much you are allowed to put in is based on how much you put down as earned income when you file your taxes.
- If you made $50,000 the first year out of college, your maximum contribution is $5,000 for 2010. Contribution limits can change every year so visit here to see this year’s limit.
- If you made $2,000 this year serving fries at McDonald’s, you put a maximum of $2,000 into your Roth IRA.
- If you made money off-the-books and don’t report it, you cannot contribute.
- If you didn’t make any money, you cannot contribute.
- If all you got this year was $3,000 from Mom and Dad, you cannot contribute.
It is possible to make too much money when it comes to contributing to a Roth IRA – a high salary would decrease the amount you contribute for a particular year. If this applies to you (I’m so jealous), the IRS website breaks it down for you.
Taking Money Out
Young adults shun the idea of the Roth IRA when they hear that the money is locked in until they reach the age of 59 1/2. There is a reason they call it an “individual retirement account” – it’s your survival money when you retire and have little to no income. While there are exceptions to withdrawing from your Roth IRA, each penny in it was designated for ‘the-older-you’ and not meant to be taken out on a whim.
Tax Advantages
With a Roth IRA, your contributions are made with post-tax income and distributions (or withdrawals) are tax-free. With a Traditional IRA, your contributions are made with pre-tax income and distributions are taxed at the rate of the year they are made. With a regular brokerage account, there is no limit on how much you can put in it but all capital gains on your investments will be taxed.
Essentially, with a Roth IRA, you are betting that the future tax rate (when you reach the age of 59 1/2) is going to be higher than the current tax rate because you are choosing to be taxed earlier rather than later.
Not So Complicated
Opening a Roth IRA can be done at online through most banks and brokerages in less than 10 minutes – just like opening an regular bank account. Work your butt off and contribute as much as you possibly can.
The hardest part for me was probably designing my portfolio allocation and picking the right investments. And that is something that should definitely take more time to understand than the Roth IRA.
If you are interested in learning more about the Roth IRA, visit the IRS website here.
(Photo credit: stevendepolo)
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4 Comments on this post
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Josh said:
This site is awesome. Love the education. I do have question or two – hope you are able to help clarify:
1. Between me and my wife, can we put 10,000 (for 2009 yr – I know the deadline was today but I am just asking) in ROTH IRA? Could we open a joint IRA account at lets say Fidelity and have 10,000 deposited or do we have to have separate accounts since one person limit is only 5,000?
2. I have 401K at work and wife does not (she has pension but she won’t qualify for another yr). I know I can put 16500 max (again assuming 2009 limits) in my 401K but I am confused between 401K, traditional and Roth. If I did put 16500 in my employer 401K, can I also put 5000 in traditional IRA and 5000 in Roth IRA? That is total 26500 per person allowed to be deposited in retirement account, correct? I do know that only 21500 is pre tax and 5000 in Roth is after tax.
3. Since my wife doesn’t have 401K at work, can she only do traditoinal and Roth totaling 10000? Is there any other way to save more? (I know she has option to get paid on 1099 basis vs W2 fm work – would that be beneficial over getting paid in W2?Thanks a bunch.
April 15th, 2010 at 3:00 pm -
Simon Zhen said:
@Josh: Thanks, I always appreciate the compliments.
As to your questions:
1. You can contribute $5,000 to your own Roth IRA and your wife can contribute $5,000 to her own Roth IRA. Joint IRAs do not exist.2. 401k’s are separate entities when dealing with IRAs. Put as much as you wish (up to the max) in your 401k. It is possible to have 20 Roth IRAs and 20 Traditional IRAs but you can only contribute a TOTAL of $5,000 across all of them, NOT $5,000 towards each – (but that would be pretty cool if we could).
3. Again, $5,000 total across traditional and Roth IRA accounts is the max she could contribute. Whether she get paid through 1099 or W2, nothing changes because income is income. Other possible options would a taxable brokerage account and deposit accounts (CDs, money market accounts, and high yield savings accounts).
If you and your wife carry any form of debt, it would be wise to pay them down. From your questions, it sounds like you and your wife are on a great financial path!
Note that I’m no financial professional so it would be best to check one out regarding you specific situation.
April 15th, 2010 at 5:19 pm
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