What You Need to Know About Traditional and Roth IRAs

Why you need to know this: A Roth IRA is the retirement account financial planners say all young people should have.

I don’t know how to stress this enough: If you’re not already saving for retirement (i.e. through a 401(k) plan at work) open an IRA account. Do it.

An IRA is an Individual Retirement Account, and putting money into an IRA is the easiest way to have lots of money when you’re ready to retire (because of this thing called compound interest that I’ve already talked about).

Okay, stay with me because this might get boring, and I’m trying not to make this boring. I want you to have more money than you ever dreamed of when you’re an old person, and IRAs make this possible. You might be thinking, ugh, retirement. That’s like, 40 years away, and I don’t want to even think about it right now!

Don’t think that. That’s dumb. I know it’s worth it to put money into a retirement account when you are in your twenties, because I have a retirement account that I opened when I was 25, and there is so much more money in that account right now than I originally put in it.

There are two types of IRAs: A traditional IRA and a Roth IRA. A traditional IRA works very similarly to a 401(k) in that you can put tax-free money into an investment account. You only pay taxes when you withdraw the money during retirement.

A Roth IRA uses after-tax money, which means you can invest money that’s already been taxed from your paycheck, and you won’t have to pay any taxes when you withdraw the money during retirement. A Roth IRA is also the investment account that almost every financial person says a young person should have. So if you’re choosing between a traditional and a Roth IRA, you should definitely open a Roth. The current limitation is that you can’t invest in a Roth if your adjusted gross income is more than $125,000 as a single person, or $183,000 as a married person, but I’m guessing that if you are a young person reading this, that’s not going to be an issue (but if you are earning more than that — whoa, congratulations, put your money in a traditional IRA).

Other things to know about a Roth IRA:

• You can’t contribute more than $5,000 a year into a Roth IRA (or $6,000 if you’re over 50). You can contribute to both a Roth and a traditional IRA, but the sum can’t equal more than $5,000 ($6,000 if you’re over 50). The deadline to contribute to your Roth IRA is the same as the tax deadline. So if you want to make a contribution for 2011, you have until April 15, 2012 to do it.
• You will have to pay a penalty tax if you withdraw any earnings from your Roth IRA before you are 59 and a half years old. But, you’re allowed to withdraw the money you invest in the account at any time without a penalty. So if you put $5,000 in a Roth IRA, you can withdraw that $5,000 any time you want (But, don’t do that. The whole point of putting your money into an IRA is to earn more money. You won’t earn more money if you take it out).
• If your account has been open for at least five years, you can withdraw up to $10,000 — including earnings — to buy your first home. This is another reason why you should open an account as soon as you can.

How to open a Roth IRA account:

Before opening a Roth, Jay Hutchins, a financial planner in New Hampshire, tells me that you should make sure you have some sort of emergency fund set up. You need something to fall back on in case of an emergency, and your Roth IRA shouldn’t be it. Also, don’t ignore your credit card debt. Make an effort to eliminate that debt while you’re investing in your IRA.

Okay, now that we’ve got that settled, you’ll need the following things to open an account:

• Your social security number
• Your driver’s license or another form of ID
• Your bank account information (routing and bank account numbers)
• Your employment information (name and address)
• Names, social security numbers and birthdates of people you want to designate as your beneficiaries (who you want to have your money if you are dead)

Next, figure out where you want to open your Roth IRA. You can use a discount brokerage company like E*Trade, or Schwab. Discount brokerage firms charge clients lower fees, but sometimes offer fewer services than bigger brokerage firms (like offering investment advice). Or you can open an account at one of the big three firms — Fidelity, Vanguard and T. Rowe Price — which provide much more services (personally, I chose one of the the big three — Vanguard — because I like having more options available, and because of their low fees). Some firms will require that you have at least $1,000 available to deposit to open an account, but there are also other plans available for people who are starting out with less than that. T. Rowe Price, for example, has a program that allows you to invest as little as $50 a month in a Roth, as long as you sign up for an automatic investment plan.

Once you’ve figured that out, you can open an account online, over the phone, or at a brick and mortar location. The rest of the process should be easy because whoever is helping you will explain everything you need to do.

The last thing you’ll have to do is choose investments for your account. You can ask your brokerage firm for advice, and do some research using Morningstar, a financial data provider. Christine Benz, director of personal finance at Morningstar, says that if there is one single fund she recommends, it’s Vanguard’s STAR fund, which is a balanced fund consisting of 60 percent stocks, and 40 percent bonds with moderate market risks.

You’re off and running! Congrats — you’re now ahead of the game.

Recap!

• There are two types of IRAs, traditional IRAs, and Roth IRAs. A traditional IRA works similarly to a 401(k) in that it uses pre-tax money for investments. You will pay income taxes on money you withdraw during retirement. A Roth IRA uses after-tax money for investments, which means you won’t have to pay any taxes on money you withdraw during retirement.
• A Roth IRA is the investment account that most financial advisors suggest young people have.
• You cannot open a Roth IRA if you earn more than $125,000 as a single person, or $183,ooo as part of a married couple.
• You cannot contribute more than $5,000 a year into a Roth IRA ($6,000 if you’re over 50). The annual deadline to contribute to your IRA is the tax deadline: April 15th.
• You will have to pay income taxes and a 10 percent penalty tax if you withdraw earnings from a Roth account before you are 59 ½ years old.
• If your Roth account has been open for five years, you can withdraw up to $10,000 from your account to buy your first home.

Support The Billfold

The Billfold continues to exist thanks to support from our readers. Help us continue to do our work by making a monthly pledge on Patreon or a one-time-only contribution through PayPal.