Money To Live

August 18, 2008

Reader Question: Individual Retirement Accounts

Filed under: retirement,savings — by moneytolive @ 5:00 am
Tags: , ,

A reader wrote in requesting information about Roth IRAs. If you would like to read about something, let me know in the comments or on the contact form.

An Individual Retirement Account is an account that you set up on your own (as opposed to through your employer), and you are the only owner of it (as opposed to a joint account with a spouse).

Some decisions to make:

  • Should I open an IRA or invest the money in a taxable account?
  • Where to invest?
  • Roth or Traditional?
  • How much to invest?
  • How will I invest the money?

Advantages of an IRA over a taxable account:

  • The money is “off limits.” There is an extra 10% penalty to withdraw the money for a non-qualified reason (i.e., a vacation). It is like your mom holding your allowance to help you save up for a new bicycle, but in this case the bicycle is retirement.
  • The money grows tax free. You do not have to pay taxes on stock dividends or bond interest.

Where to invest? Most of the large investment firms are fine choices, especially Fidelity and Vanguard. My favorite firm is Vanguard; the fees are very low. If you are a member of USAA, it might make sense to invest there, keeping all of your accounts in one place. For buying and selling individual stocks, I use E*Ttrade.

How much to invest? The government sets limits for the maximum amount that can be invested in an IRA. In 2008, the maximum amount is $5,000 for individuals age 49 and under and $6,000 for individuals age 50 and over. Individuals with high incomes may not be able to contribute.

Invest as much as you can while still covering your expenses. It can be pretty disappointing to contribute $1,000 to an IRA only to discover that the minimum contribution for all of the funds is $3,000. Just keep contributing until you reach the minimum amount needed.

Roth IRA vs. Traditional IRA. With a Roth IRA your contribution is taxed the year it is contributed, but earnings are not taxed upon withdrawal. With a Traditional IRA, you can deduct the contribution on your income taxes, but when you take a withdrawal, it is taxed as income.

Which is better – Roth or Traditional? The short answer is that if you are young and satisfy the Roth income limits, you are better off putting the money in a Roth IRA than a Traditional IRA. The long answer depends on what you believe will be the income and capital gains tax rates when you retire.

What to buy? The easiest thing to do is buy low-cost index funds and mutual funds. One great option is a Target Date fund (or Life Cycle fund, each investment company calls it something slightly different). Figure out when you want to retire (for me, it’s 2045), and buy shares in a fund with that date. The fund automatically rebalances (changes the ratio of stocks/bonds/cash, to be in line with that retirement date).

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If you still want to know more, here is a brief history of the IRA.

Individual Retirement Accounts were introduced in 1974 by the Employee Retirement Income Security Act (ERISA), and individuals could not contribute if they had an employer-sponsored retirement plan.

Roth IRAs were introduced recently in the Taxpayer Relief Act of 1997.

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More info on IRAs

All About IRAs (Fool.com)

Which IRA is best for me? (Vangurad.com

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