Why You Need a Roth IRA
Jul. 6, 2016 Kiplinger
One of the smartest money moves a young person can make is to invest in a Roth IRA — and setting one up is easy.
Follow the rules, and any money you put into one of these retirement-savings accounts grows absolutely tax free: You won’t owe Uncle Sam a dime as you let your savings accumulate, or when you cash out in retirement. Plus, an IRA is more flexible than a 401(k) and other retirement plans because you can invest it in almost whatever you want, from stocks and mutual funds to bonds and real estate.
If you haven’t yet opened this gift from Uncle Sam, do it now. You have until your tax return deadline to set up and make contributions for the previous tax year. The government sets a limit on how much you can contribute to a Roth. The limit is $5,500 for 2014 and 2015. That means you can invest up to $5,500 to count for tax year 2014 if you act before April 15, 2015, giving you a solid start to your savings. Although you have until next year’s tax deadline to kick in your $5,500 for 2015, the sooner your money is in the tax shelter, the sooner the tax-free earnings begin to accrue.
For those just starting out, the power of this tax shelter may seem a tad obscure, but it can really pay off big. If a 25-year-old contributes $5,000 each year until she retires and makes an average annual return of 8% on her investment, she’ll have $1.4 million saved by the time she retires at age 65. And the money is all hers — she won’t have to give the IRS a cent of it if she waits until retirement to withdraw the earnings.
If that same 25-year-old invested that same $5,000 a year in a taxable account earning the same 8% return, she’d only have about $1 million after 40 years if her earnings were taxed at 15% each year. That’s more than one-fourth less money than if she’d gone with the Roth. If state taxes bit into the earnings each year, too, she’d be down even more.
As with any government gift, the Roth IRA comes with a few strings attached. First, you can contribute to a Roth only if you have earned income from a job. Say you’re in school, you’re not working and you have a little extra money left over from your student loan or your parents gave you money. You cannot put it in a Roth. Also, you cannot save more than you made. So if you worked a summer job and made only $3,000, the most you could contribute to a Roth would be $3,000.
It’s also possible to make too much. You can contribute the full $5,500 in 2015 as long as your income falls below $116,000 if you’re single, and $183,000 if you’re married filing a joint tax return. The contribution limit is then phased out incrementally if you make between $116,000 and $131,000 (single) or $183,000 and $193,000 (married-joint). (See IRS Publication 590 for more on calculating your contribution.) Those income limits go up each year, but if sometime in the future your income breaks through the ceiling, don’t worry. You won’t have to liquidate your Roth; you’ll just be prevented from making additional contributions.