Many people who are new to investing are excited about the prospect of using the money their capital can earn in order to grow wealthy. Each individual’s goals are personal and there are an infinite amount of reasons why someone may want to learn to invest. They may want to buy a bigger house, a nice car, or to have a well funded retirement just to name a few of the most common goals.
However, the financial world is full of options that can be bewildering to the beginner and confusing even to the “experts.” Fortunately, there is one step that anyone can take that will be the best financial move for a novice investor in the majority of cases. That move is to open an ROTH Individual Retirement Arrangement otherwise known as a ROTH IRA.
Even if an investor is not planning to retire during their golden years and wants to use the money for some other purpose, such as a home or a vacation, a ROTH IRA account is usually the best vehicle for their investing. As we’ll see, it is well suited to just about any investment goal though it was originally designed to encourage individual retirement savings.
The ROTH IRA was established by the Tax-payer relief act of 1997. It can trace its origins back to the traditional IRA which was started by the Tax-payer relief act of 1986. Both of these laws were created due to the obvious fact that middle-class Americans weren’t saving enough to fund their own retirements in a world where social security was not as secure as it had been in the past. While the traditional IRA was a step in the right direction, because the number of restrictions applied to it was not outweighed by the benefits, it was found not to be as effective in encouraging saving as the lawmakers had originally intended. Thus, a new type of retirement account was created that was more generous to middle class American taxpayers. This account was the ROTH IRA.
ROTH IRA vs. a Traditional IRA
In a traditional IRA contributions are made tax free. For example, if in 2012 an investor contributed the maximum $5,000 to the traditional IRA, their income tax return would show a decrease in earnings of $5,000 for which they would receive a refund. Depending on the owner’s tax bracket, this refund would be small or large. Investment returns on the contribution would then be left untaxed until the investor made a withdrawal. Withdrawals from a traditional IRA are usually made after the age of 59.5 in order to avoid penalties. When they are withdrawn, the gains are treated as regular income and taxed at the current rate at the time of withdrawal.
This type of account differs from a traditional IRA in one important aspect: a contributor does not get a tax break from contributing to the IRA. This means that every dollar contributed has already been taxed by the United States government at the time it was earned. In exchange for taxes now, the government agrees to not take any taxes out on future earnings made with that capital. Thus, if ROTH IRA contributions earn interest, dividends, or capital gains at any time in the future then those earnings are untaxed, even at withdrawal.
Advantages of a ROTH IRA
The primary advantage of the ROTH IRA is the fact that any earnings are non-taxed: forever. This means that as the years go by the account accrues ever increasing amounts of capital due to compounding interest. Because all earnings are non-taxed, the amount that would usually paid to the government each year can be reinvested and therefore increase the earnings for the following year. This increases the rate of compounding dramatically.
Also, unlike a traditional IRA, when a withdrawal is made after the age of 59.5 it will never increase the owner’s Adjusted Gross Income. This means that even if there is one million dollars in the account and the owner withdraws it all in one year, then their income statement remains unchanged in the eyes of the IRS.
Another advantage of this type of retirement account is that the principal can be withdrawn at any time without incurring any penalties. Because any contribution has already been taxed, the government views it as having already been earned and not subject to new taxes. There are, however, penalties for withdrawing the earnings above the principal amount before the age of 59.5.
This means that the principal in a ROTH account can always be removed to fund a large purchase such as a car, vacation, or college education. It isn’t always in the owner’s best interest to remove principal from the account, however, because it cannot be replaced in the future. So, while technically the withdrawal is penalty free, it does result in the opportunity cost of a smaller balance which can mean fewer tax free earnings in the future.
In addition to being able to withdraw the principal at any time, the owner of a ROTH IRA has the ability to make a one-time withdrawal of up to $10,000 in earnings, tax-free. This option is only available if the money is used to fund the purchase of the account owner’s first home.
Another advantage is that, unlike in a traditional IRA, the owner of a ROTH IRA is not required to start making withdrawals at the age of 70.5. This means that the earnings in a ROTH account can continue to grow tax free in order to be left to heirs. In addition, ROTH IRAs are not taxed when left as part of estates. This can remove a significant tax burden from the owner’s heirs.
Disadvantages of a ROTH IRA
The most obvious disadvantage to a ROTH IRA is that any money earned on the account suffers a penalty if it is withdrawn before the age of 59.5. The penalty is currently ten percent in addition to the current tax rate for normal income.
Also, funds in a ROTH account cannot be used as collateral for loans. Fortunately, they are also often untouchable during bankruptcies for the same reason.
Contributions to ROTH IRA’s are not tax deductible. Unlike the traditional IRA, a ROTH IRA will never lower the Adjusted Gross Income report sent to the IRs and thus can never increase the amount of a tax return.
Another disadvantage of a ROTH account is that just like any other investment, if the owner dies before collecting then they will never reap the rewards of their savings.
How to Open a ROTH IRA Account
Fortunately, for 99% of Americans with earned income, a ROTH IRA’s benefits greatly outweigh the disadvantages. This usually means that one of the first steps in planning for a person’s future is to set up a ROTH IRA account. Most brokerages, banks, and investment firms can easily accommodate a new investor by setting up such an account. Online brokerages have also made it extremely easy to create an account: it is usually one of the first options listed when setting up a new investment account.
If you’re new to investing it is usually a good idea to contact a financial professional. They will have the tools to explain each type of investment account and will provide the information required to make the right choices for your investment goals. Whatever investments you choose, however, it is almost always a good idea to consider placing them in a ROTH IRA to enjoy tax-free growth and a more prosperous future.
Amazon Price: $28.99 $24.00 Buy Now
(price as of Sep 14, 2016)