What is a Roth IRA?
A Roth IRA is a type of retirement account. You can open one for free at a number of different banks and institutions. In most ways it is similar to a regular investment account. You can use the money that you put into the account to buy stocks, bonds, ETFs, etc. It’s called a “Roth” IRA for Senator William Roth of Delaware who helped create it, and IRA stands for “Individual Retirement Account”
If you don’t already have a Roth IRA, you should seriously consider opening one.
There are various types of retirement accounts out there, but the Roth IRA has some special features that make it the best option for many people. Take a look at this example of how an investment will grow in a Roth IRA compared to an ordinary investment account.
In 2010, Max invests $5,000 into his Roth IRA. The same day, Ben invests $5,000 into a regular account. They each buy the same stock, which gives a 10% dividend every year. At the end of 2010, the stock price remained unchanged. Here is the result:
Max now has $5,500. $5,000 plus the $500 dividend received in 2010. Since this is a Roth IRA account, he does not owe any taxes on the dividends received.
Ben received the same $500 dividend, but has to pay 15% tax on it because his account is not a Roth IRA. So Ben has only $5,425.
Now let’s say in 2011, they each use their dividends to purchase more of that same stock. Assuming the stock price remains the same for the year, here is what their accounts will look like:
Max now has $6,050. His $5,500 earned 10% dividends this year. And he didn’t have pay a cent in taxes! Why? Because he made the investment through his Roth IRA.
Ben has only $5,886.13. He earned $542.5 in dividends, but gets taxed a rate of 15% because his account is not a Roth IRA. After taxes, his earnings for the year amount to $461.13.
Max has earned $163.87 more than Ben. As a percentage, the income earned in the Roth IRA after just two years is a whopping 18.5% higher than what was earned in the regular account ($163.87/$886.13).
So why not put all of your money in a Roth IRA? Unfortunately there are some limitations. For 2012, there is $5,000 contribution limit per person per year. Additional limitations may apply if your income is above a certain amount, or if you’re participating in other retirement accounts, such as a 401k. Here is a link to the IRS page that shows the 2012 limitations http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-for-2012
Now there are some valid reasons why you may not want to open a Roth IRA. Keep in mind that IRA stands for “Individual Retirement Account.” Generally, you can withdraw your principal (the amount that you put in) at any time without a problem. However, if you want to withdraw your earnings before you reach the age of retirement, you may have to pay a penalty unless you are using the withdrawal for a qualified reason (such as paying for higher education expenses, or purchasing your first home). Before you invest in a Roth IRA, make sure you understand all of the restrictions and limitations involved. While it may not be the right choice for everyone, investing with a Roth IRA can be a powerful tool for maximizing your investment income. To read more about Roth IRAs, visit www.RothIRA.com.
