Given all the news regarding the banking industry, Wall Street and the big bonus scandal, I want to start off this article by stating that my opinions regarding Roth IRAs are completely unbiased.
I am NOT in the investment field (thank goodness).
And whether or not you take my advice or not is a personal matter for you. As always, you should seek the advice of a tax professional and/or an investment professional before making any decisions with your money.
However, being an informed investor is better than simply sitting on the sidelines or putting your money into CDs and their less than 2% interest rates (if you’re lucky). After all, there are sound financial reasons for investing in a Roth IRA, as I’ll share with you…
Retirement plans: 401k or IRA?
Here is a little something you may not know regarding 401k retirement plans. Bear with me as we take a short detour down this road before address Roth IRAs specifically.
See, I have to discuss 401ks because of my wife.
Or rather, because of the “advice” she hears from people on a regular basis. My wife has a full time job while I’m self employed. That means steady pay and a company based retirement plan for her (in this case a 401k), and an IRA for me.
Now, the reason I have to detour into a brief discussion regarding 401ks is because of a very prevalent (and dangerous) MYTH that is floating around “out there,” which is… “You should always max out your 401k before investing into any other retirement plan.”
But that simply isn’t true at all.
For example, go ask the folks who worked at ENRON how investing in their 401k worked out for them. When it comes to contributing to your 401k there are a number of factors to consider before you simply “max it out,” such as:
- are contributions matched with funds or shares of company stock?
- how long are matching funds tied up?
- at what investment level are matching funds maxed out?
- what investment choices are allowed in your 401k
- what are the total fees for investing in your 401k?
- how much control do you have over your 401k investment choices?
In my wife’s case her company matches her investment, dollar for dollar up to 3%. Which means that every dollar invested in her 401k is matched with an investment by her company into her plan. And in her case the money invested by her company on her behalf is not tied up until she retires. There is a vesting schedule (i.e. when the matched money becomes “hers”) based on years of employment.
The important consideration, for my wife, is to make sure she contributes up to 3% of her salary into the plan because she basically doubles her money since they will match her investment.
But investing any amount more than that doesn’t really make any sense.
Because every company sponsored 401k will only offer limited investment choices based on how the plan is set up and maintained. What’s more, over time those options can change should they choose another company to manage their 401k. In fact, over the past 10 years the options allowed for my wife 401k plan have changed 3 times.
Funds we liked and that performed really well were suddenly gone, replaced by a limited choice of “new” options.
The amount of funds to choose from has gone from 100+ to 12.
Now, since all retirement plans are a long term investment strategy, basically putting money aside now for future use, control is a significant factor when it comes to deciding WHERE and HOW to invest your money.
Now, if you ask me, locking up your money in a plan you don’t control doesn’t leave you with a whole lot of choice, or options. And that’s why you should never “max out” your 401k beyond what you need to maximize any matching funds your employer MAY be giving you.
Roth IRA contributions explained
Here’s where we have to talk about taxation a bit. The rules change a lot, and I am NOT a CPA, so don’t hold my feet to the fire if I mess up a couple of small details.
Again, I’m just trying to get you thinking is all.
Here’s how taxation and retirement plans basically work… IF you put money into a plan that was never taxed (i.e. your contributions are pre-tax dollars), then you have to pay tax when you pull the money out of the plan in retirement… or when you pass that money along to you kids, or grandkids. And IF you put money into an IRA after it was taxed (i.e. your contributions are post-tax dollars) you EITHER pay tax on the investment gains only, or you don’t have to pay a dime in taxes at all.
Now, getting into all the nitty-gritty regarding #2 might take WAY too much time to really do that topic justice.
So here is the quick and dirty.
Roth IRAs are an investment of your post-tax dollars. Which means you get no deduction for contributing to them now. No writeoffs. No benefit to you today at all.
But here’s the really cool part.
When (or IF) you decided to take out the money later in life, say after you retire, OR if you decide to leave the whole amount to your kids or grandkids (or whoever), you will not have to pay a dime in taxes.
In fact, regular IRAs make you take money out after you reach 70 and a half years old (my dad starting taking money out this year). Roth IRAs don’t have that provision. Which means, you can leave the money in there for as long as you like. And your kids can leave the money in there as long as THEY like.
You are never forced to take out a penny. And when you do, you don’t pay a penny in taxes.
How cool is that!
So what’s the catch?
Great question. First, you can’t stuff as much money in there as you would like. There are caps as to how much you can contribute each year. And if you earn more than the contribution limit allows, you can’t even open up an account. There is a way around it for self-employed people, and that’s by setting up a Roth 401k… but that’s another story.
So, the bottom-line is this:
- if you make too money you can’t have one
- you can only contribute so much money into a Roth IRA each year.
But since you can choose any darned funds you want (or whatever), you might want to look into a Roth IRA.
When it comes to getting investment advice make sure you speak with a registered investment advisor or certified retirement plans specialist.
Or a certified financial planner.
After all, the most dangerous advice to follow is given by well-meaning people like friends and family whose hearts might be in the right place, or who might simply tell you what you want to hear so that they don’t hurt your feelings.
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