Can you explain Roth IRA's to me in idiot terms?

In My Humble Opinion
1

I’m a 21 year old guy, and over the years I’ve read a whole bunch of stories about how if individuals my age were to begin their retirement savings immediately, then their initial savings would somehow manage to balloon to well over a million bucks by the time they retire. Well, I’m a forward thinking person so I kind of want to do that.

The thing is, I know jack shit about the stock market or investing or all of those other financial shenanigans. I’m honestly the kind of person who would rather automate the entire process, ie setting aside the initial savings and putting it on its way to invest itself. It’s my understanding that that sort of setup IS possible, but I wouldn’t know how to go about it.

So, more esteemed members of the Dope, could you help me get a handle on this Roth IRA stuff?

2

It’s easy.

  1. Open Roth IRA
  2. ???
  3. Profit!

Lol. Had to do it.

Anyway, the real answer is that retirement accounts defer taxes. In a Roth IRA, you contribute money to it after you pay your regular income tax on it, but you don’t pay taxes on capital gains and dividends in your account, ever, even after you withdraw them. A Traditional IRA is slightly different - you can deduct allowable contributions to your IRA (e.g. if you contribute $2000 to your IRA in a certain year, you simply don’t owe any taxes on it and it is deducted from your taxable income), and you don’t have to pay capital gains and dividend taxes in your account until you take the money out. When you take the money out, you pay regular income tax on whatever you take out, so you end up paying tax at age 70 on the money you contributed at age 25 and that grew tax free for decades.

What’s the downside? One of the biggest ones is that if you need the money before a certain minimum retirement age, the IRS rapes you with taxes and penalties.

3

If the company where you work has a 401(k) option, this is like a traditional IRA only it is automated by your company. You can set the amount (usually up to 15% of your gross salary) and change the amount if you want to save less or more.

Some companies will also do some matching contributions to your 401(k), which is like free money.

Within the 401(k) plan there are a manageable number of options for which kind of fund you want to invest in (or you can spread your investment over several different funds). The most no-hands approach is to select a fund that is managed with a view towards the year you expect to retire. In those cases, the fund is invested more heavily in growth stocks early on, and it gradually switches to bonds (this is a very simplified summary). The main thing about these is that you can set it and forget it. You may not get the best growth or profit, but theoretically you get the best balance of growth vs. security (as defined by the professional fund managers).

Bear in mind that any investment, including a 401(k) or an IRA of either kind is still an investment, and still involves some risk. Almost everyone lost some value in their funds during the recent huge recession, and although most have recovered the totals are not where they would have been without that event.

However, overall and compared to alternatives (investing yourself, not saving at all, buying gold, for some examples) this approach seems to have the best results for long-term saving for retirement. If you want to save for other purposes (children’s education, buying a house, buying a car), you should look at other products, because you usually cannot withdraw funds from these retirement accounts until you are 59-1/2, or else you pay a big penalty.

If you can find a “Retirement Savings for Dummies” book or equivalent, I recommend it. I think you will find that, if you do start saving now, you will be way ahead of your contemporaries with a lot less effort when retirement does come around.
Roddy

4

Congratulations to you for thinking about this at 21. You really will be getting a great head start on your retirement savings. Here’s the simple guide:

  1. Go to a discount brokerage either in person or online, and tell them that you want to set up a Roth IRA. I use Fidelity, but there are others such as Vanguard and Charles Schwab that will do essentially the same thing.

  2. If your employer allows you to split your direct deposit, have some amount go into the Roth each paycheck (your discount brokerage can give you the appropriate routing numbers). If your employer can’t do this, set up a certain amount to be transferred to the Roth each month from your checking account, scheduled for a few days after your paycheck is deposited. Note that the total amount you can deposit per year for 2013 is $5,500, so schedule your monthly or biweekly amounts accordingly.

  3. Use the tools online at your discount brokerage to set up an automatic investment each month, so that the money being deposited is being invested. At your age, you probably want to be 100% in stocks. An S&P 500 index fund is a good choice. Find one that doesn’t have a fee (sometimes that means the one that is associated with the brokerage you have chosen).

  4. Sit back and wait for your nest egg to build.

I set up this entire process about 10 years ago. I literally never have to think about it or check it unless I choose to, and the amount of growth I have seen is remarkable, even with the Great Recession. By 2059, you should be in great shape to retire.

5

Your “set it and forget it” investment should be your 401k. That comes out of your pay and you never see it so you don’t miss it. Definitely do this. 15% is good. 20 is better.

The Roth IRA is something I usually do with “found money”. Switch jobs and get a signing bonus? Get an end of year bonus? Get a tax refund? Get cash back on your credit card for points earned? All of these things I put into the Roth. You are only allowed a limited amount each year. It goes up yearly. When I first started it was only $3,000 and I always maxed it out. As you get older it gets tougher because you have more responsibilities and a mortgage.

Setting it all up can be daunting, but it’s easy if you let the provider do most of the work. Call a real company, not some small shop. Fidelity and Vanguard are both good. They have trained reps that walk you through the process. It’s OK to start your Roth with just a small amount. You’ll be more likely to use it if it’s there and already set up when you get some cash to save.

As to how to invest it, just pick a few index funds, or even a fund that invests in indexes and gradually gets more conservative over time (called “target date” funds usually.) Don’t worry too much about this part. It’s more important just to be doing something than trying to pick the best mutual fund.

You’ve got the right attitude. Just don’t forget to keep putting money in.

6

There are “target date funds”, which are a type of mutual fund set up to be pretty much automated. You say, “I want to retire in 20XX” and the fund handles all of the risk/reward/knowing about investment classes/re-balancing for you. So if you get an IRA with one of these funds as an option, you can just put all of your contributions into it and be done.

I kind of imagine that you can get better results with a more hands-on approach, but if you want to prioritize simplicity, that’s a good option.

7

Roth IRA’s in a nutshell:

The IRA can be setup at a bank or brokerage or other financial institution.

A Roth IRA works by contributing money each year to the retirement account. The money that you contribute is “after-tax”, meaning all taxing authorities have already taken their cut of the pie on it.

Currently, the maximum per year an individual can contribute to a Roth is $5,500 to the account, or $6,500 if they are over age 55. This amount may increase in future years with inflation. This yearly cap does hurt those who wish to put in more but are prohibited from doing so. You must also “earn” at least the amount you want to put into the Roth IRA each year. So you must have W-2 or 1099 or other “earned” income (not investment income) of at least $5,500 currently to contribute that amount to a Roth. You can contribute to the Roth at any time during the year, and up to April 15th of the following year. So, if you want to contribute to a Roth next March, you can choose whether you want that contribution to be applied to 2013 or 2014.

There are also income limits to be eligible to contribute to a Roth. Currently, for single taxpayers, Modified Adjusted Gross Income (calculated on your yearly tax return) can be no more than $127,000 (and the maximum contribution begins to be reduced at $112,000). For Married filing Joint, the income limit is $188,000 (and starts to be reduced at $178,000). If your income is over these amounts, you cannot contribute to a Roth in the year that your income exceeds those amounts. Any prior Roth contributions are fine.

Once the money is in the Roth IRA, you can direct the funds to be invested any way that you would like. Any earnings on the account in the form of dividends or capital gains are not subject to tax. When you contribute funds each year you do not get any sort of tax deferral or tax deduction, however, which is different than Traditional IRA’s and other retirement plans.

Once you reach age 59 and 1/2, you can start to withdraw funds from the Roth without a penalty. If you withdraw funds before age 59 and 1/2, you have to pay a 10% penalty on the amount of any earnings (not principal, since that has already been taxed) distributed. Once past age 59 and 1/2, all distributions are completely tax-free. You are not required to start taking money out of the Roth until you reach age 70 and 1/2, however. At that time you are required to start taking required minimum distributions (RMD’s) which are based on the value in your account and actuarial tables.

The biggest benefits of a Roth compared to other retirement plans is that you do not have to pay any tax on the distributions once you take them out in retirement. You are also able to invest the money in the Roth any way that you see fit, as aggressively or conservatively as you like.

At your age, a Roth is usually a very good retirement vehicle, especially if you also have an employer-sponsored retirement plan you can contribute to as well, as the yearly cap on Roth contributions makes it difficult to build up a really large retirement account using just a Roth.

Hope that helped.

8

I am not a tax accountant or anything like that…but here is my understanding.

Just wanted to reinforce something that has been noted already.

Since you already paid the tax on the money you are putting in there…you can take it out at any time, without tax or penalty. Just like you would a regular bank account. Where they will stick it to you at withdrawal time is if you withdraw any interest earned before 59 1/2. But once again on the plus side, the assumption even the IRS makes is that withdrawals come from your own contributions first. So if you have records showing you put the money -in- , you can take it out.

And yes, I’m not 59 1/2 yet and I have taken money out of my Roth. The IRS did send a nice letter inquiring about it. I replied with my proof of deposits and printed copies of their own regulations. Never heard another peep outta them, and that was a couple of years ago.

Do a 401(k) or similar first, especially if you work for any company that puts in any kind of match. A company match is found money…don’t walk away from that.

A Roth IRA is a good leg to include in a retirement strategy, but you need more than one leg to make a stable platform.

9

I just started a Roth in February, this year (in addition to my sorta-traditional work sponsored 401k) with Schwab. I have my dollars in a no load target fund, 5 star rating by Morningstar and I’m just shy of 10% YTD. I may diversify a bit after another year or two, but the target funds are probably as safe as anything you would put into a company sponsored 401k and you have the option of getting more involved at any level you want, whenever you want. You can switch that shit from long term bonds to “put it all on red” :wink: at the drop of a hat. As an aside, I’m really happy with Schwab in general. I don’t even use a local bank anymore. Investor checking and outstanding customer service persuaded me to close my local account after HSBC bailed on the consumer market.

I don’t necessarily agree with this. You can automate payroll deposits to a Roth as easily as you can to your 401k. Certainly 401k employer matching should be maximized before considering Roth, but I don’t think the benefits of compound returns against nontaxable future withdrawals should be dismissed outright. Especially for a 21 year old investor. I’m not a money guy, but the long term benefit seems clear to me. The much more limited income and deposit limits seem to back up the fact that it’s more advantageous for the investor than for long term government tax revenue.

10

Let’s say I set up a Roth. Does that affect my max contribution to a 403(b) or Traditional IRA?

11

No, Roth is investment of net income. You’re limited by annual contribution based on gross income, but it doesn’t affect 403b or 401k contributions any more than a standard brokerage account would. You can fully fund all of these accounts to their limits.

12

Assuming you are talking about a Roth IRA and not a Roth 401(k), your combined annual contributions to your Roth IRA and Traditional IRA accounts (added together) cannot exceed your annual limit.

Your 2013 annual limit is $5000 ($6000 if you are age 50 or more) or your 2013 taxable compensation income, whichever is less. If you file a joint return, you can count your spouse’s taxable compensation.

In other words, if you are under 50 and you have a taxable salary of at least $5000,
you can contribute $5000 to a Traditional IRA or a Roth IRA, but not both. You can also split your contributions, for example $1000 to a Traditional IRA and $4000 to a Roth IRA.

There is also an upper income limit on contributing to a Roth IRA. It’s complicated and I don’t want to type it all in. Here it is if you care. If you exceed this limit, you cannot make a Roth IRA contribution (or can make a reduced contribution). A few years ago, Congress created the “backdoor Roth IRA” loophole that essentially allows you to circumvent the limit if you are under age 70.5 by first making a Traditional IRA contribution and then converting it to a Roth account. The conversion may or may not be taxable, depending on a variety of circumstances.

There is no upper income limit on a Traditional IRA contribution (just the age limit). But if you are over a certain income threshold and covered by a retirement plan at work, your ability to deduct the Traditional IRA contribution may be restricted.

Your contributions to a Roth IRA or Traditional IRA do not affect your 403(b) plan.

13

$5500 and $6500 respectively, for 2013. You’re posting 2012 limits. The income restrictions are <$127k single, <$178 jointly

Also, I MADE A HUGE MISTAKE, and I spotted it from Alley Dweller’s Link.

Traditional IRA is NOT 401k. Sorry about that, Saint Cad. The $5500/6500 limit applies to the combined total of your traditional IRA and Roth, so yes. A Roth IRA will absolutely affect your traditional IRA, which I erroneously interpreted as 401k. Again, my apologies.

14

Also, after he said it in plain english in the preceding post.

Sorry, It’s late. I will bow out of this thread for good.

15

I can’t answer in any but the vaguest terms or compliance will stomp me flat.

But Roth IRAs are very good investments for the young as they give maximum time for the compound interest effect to take over.

16

Right, you can withdraw your contributions before 59.5 without penalty, but withdrawing your earnings before then is when you’ll have to pay.

17

I agree with most of what is said here but I would not go for a target date fund at your age. The most important thing for the “set it and forget it” is to split up your contribution so that you put in a certain amount each month. If your employer does not match funds, a Roth IRA is your best option because you will be able to invest in whatever you want if you choose to do so in the future.

Here is how I did mine. I set up my Roth IRA with Schwab (but as noted above, you can use other firms). I called them and they walked me through everything. Once a month I have $500 automatically withdrawn from my bank account and sent to Schwab . I chose $500 because it’s an even number that is easy to keep track of. After the maximum contribution is reached ($5500 this year) they stop withdrawing and restart again the next year, which basically means that nothing is withdrawn in December. Every month I then have it set up to invest about $450 from the Roth account into an index 500 fund (so that over the year I invest the full amount). This creates what is called “dollar-cost averaging” so that when the stock market goes down a little you buy more and when it goes up you buy fewer shares. Then I can sit back and do nothing.

In short:
1)Choose a low-cost brokerage firm
2)Set up a monthly transfer directly to the firm
3)Have the firm automatically invest this money each month in a low-cost, diversified investment such as an index fund
4)Profit

The investment firms will help you with the whole process if you call them. They hire people just to answer phones and help you with these things.

18

Yes, the food chain goes 401(K) > Roth IRA > Traditional IRA > Tax Deferred Annuity.

Since no one has talked about the last one yet, I’ll throw that out as well. The first three all have fairly low limits in the grand scheme of things that can max out when you start making more money in your 40s of 50s if you move into a management role at a good company. Likewise, you may have some large amounts of found money in the form of inheritance or investments like the purchase of a company where you hold stock. The Tax Deferred Annuity acts like the Traditional IRA, except it has a yearly limit of $3 million. If you need to defer more than that per year, saving for retirement isn’t your biggest problem, it’s the mountains of cocaine in your house you need to protect, and the supermodels you’ve yet to sleep with…

19

I believe “they all say” that you should, in the following order

  1. put enough in to get the maximum employer matching
  2. max out your IRA (Roth or whatever)
  3. Max out the 401(k)

But in any event, put aside as much as possible at this point, one way or the other.

At age 21, your income (and therefore tax rate) is probably not all that high. So a tax-deferred contribution won’t offer you much benefit right now, when you might well be earning more and at a higher tax rate later on when you want to spend that money. So my WAG is that even if you were eligible for a deferred IRA contribution, I’d suggest going for Roth for the IRA.

Of note: there is also a Roth-type 401(k) vehicle. Not all companies offer this, however. Mine does as does my husband’s. If your company does, it’s worth considering for the same reasons (young, income relatively low). As it happens, we are putting more in the traditional portion, because at this point we need the income tax savings, but we do try to contribute a bit to the Roth portion.

The nice thing about the Roth 401(k) vs. a Roth IRA is that it falls under the 401(k) contribution limits, and also you aren’t hit by the income limit.

As others have noted, you can access Roth contributions (but not income on them) prior to age 59 or whatever, without penalty. Now that you know that, forget it. Treat that money, mentally, like it’s as “tainted” as regular IRA money.

20

I agree with psychobunny - but would add that Vanguard index funds are the way to go and the Bogleheads Wiki is a great reference (the forum is a confusing pit at times, but there are a few very knowledgeable and professional posters among the rabble).

Congrats on thinking about this at you age - I wish I had instead of getting serious about it in my mid forties. I have retired and will be Ok, but I got very lucky (and had no kids).

Don’t sweat the details too much at this point and don’t get caught in ‘analysis paralysis’ and delay - time is your enemy. Start a regular transfer from your paycheck now. If your checking account never sees the money, the temptation to spend it will go away. Increase that amount with each raise or bonus. When the IRA maxes, opens regular taxable account. NEVER take funds or a loan from the IRA until you retire.

Two stories to pass on:

At 45, I found an article that pointed out that if you made a $2000 yearly contribution for age 20-30 and stopped, you would have more at 65 than someone who started at 30 and stopped at 65. Compound interest is powerful.

I recently tracked the details on a long ignored retirement plan from a job I had for 5 years at age 25. I did not think about it or contribute at the time, but the 3% employer contribution of $2100 has grown to $55,000 in 34 years. I could have easily added 6% to it - probably more but I did not…

Pm me if you want more details or example spreadsheets showing compound interest effects.