Financial Thoughts - Roth IRA

The Roth IRA. This is one of my favorite investment accounts to talk about. If you have known me for any length of time and we have ever discussed finance, I have probably asked you if you have a Roth. It is one of the best savings and retirement accounts you can have. So, let's begin with describing what it is.

A Roth IRA is a retirement account differs from a regular IRA in what amounts are taxed at what time. In a traditional IRA, you can deduct your contributions from your current year's income. In a Roth IRA, you must still claim the contributions as income. However, the traditional IRA is fully taxable when you begin to withdraw from it upon retirement. But all withdrawals from a Roth IRA upon retirement will not be taxed. This difference is enormous!

Let's work through an example. Right now the maximum amount you may contribute to an IRA (traditional or Roth) is $4,000 per year. So let's take that amount, with our standard safe 8% earnings rate, and assume a 30 year timeline. Let us also assume you are in the 20% marginal tax bracket while you work and after you retire.

With a traditional IRA, we would invest $4,000 per year for 30 years, and would get to deduct that from our income, saving ourselves $800 in taxes (20% tax rate times $4,000). However, at the end of the 30 year period, when we start to withdraw the money from the IRA, the entire amount is fully taxable. We would end up paying in excess of $90,000 in taxes, if we took the entire amount out at once (and even more if we did not).

With the Roth IRA, we would invest the same amount for the same period, but still be required to claim the $4,000 as part of our income. It would cost us over the course of the years around $24,000 in taxes. However, at the end of the 30 years, the entire amount in the Roth is tax free. This leaves us considerably more money to live on.

Another advantage of a Roth IRA is one that I highly recommend NOT using, but it is available. You may withdraw any amounts that you put in the Roth without penalty. You may not withdraw any of the interest it has earned. However, this is a very bad idea, because this will significantly reduce your earnings potential. But it is available if you need in emergencies.

Where does one open a Roth IRA? You may open one at any major investment house, such as Vanguard, T. Rowe. Price, Fidelity, TD Waterhouse, etc. Research the funds the company offers and the track record of those funds. Seek the help of a financial advisor if you aren't sure what to do. Happy Roth IRA saving!!