2014 Roth IRA Starter’s Guide for Investors

Introduction to the Roth IRA

What is a Roth IRA?

To begin understanding what a Roth IRA is, you must first understand what the general term IRA refers to. An IRA refers to an Individual Retirement Arrangement, although most people refer to it as an Individual Retirement Account. An IRA is simply an account title and when you open one, there is actually not anything inside of it.

The IRA account owner must fund the IRA with their individual investment selections. For example, an IRA owner could buy cash investments, individual stocks and bonds, mutual funds or even real estate investment trusts (REITs). The most important thing to remember is that an IRA itself is not an investment, but a type of investment account.

Why Choose Roth IRA vs Traditional IRA?

There are many differences between the Roth IRA and traditional IRA account. Please read Roth IRA vs Traditional IRA to understand which is best for your retirement.

Roth IRA Rules

To understand the Roth IRA income rules, refer to our 2014 Roth IRA Rules article.

Understanding Roth IRA Distributions

It is important to take a closer look at the way in which Roth IRA funds are treated. If Roth IRA funds are withdrawn prior to the age of 59 ½ and are not used as a first home purchase, they are subject to income taxation and an early withdrawal penalty of 10%. In order to withdraw Roth IRA funds that will not incur a penalty or taxation, it must be considered a qualified withdrawal. Here is how the IRS currently classifies a qualified withdrawal:

  • The withdrawal took place at least 5 years after the Roth IRA account was established
  • The account owner is 59 ½ when the funds were withdrawn
  • The Roth IRA is considered disabled when they withdrew funds (restrictions apply)
  • Roth IRA beneficiary received funds after the owner’s death
  • The funds will be used towards the purchase of a first home by a qualified family member or the account owner, which is limited to $10,000.

Roth IRA Calculators

You’ll need to use a roth ira calculator to figure out how much you should save each year.

Roth IRA Calculator
Current IRA Balance:
Contributions Per Year ($):
Years Until Retirement:
Expected Rate of Return (%):

Here’s a list of the best Roth IRA calculators:

Roth IRA Conversion Rules

Grow Earnings Tax Free

The Roth IRA is a unique account in that other funds in a qualified retirement account may be eligible for conversion into a Roth IRA. One of the primary reasons that someone would consider this option is that the funds once they are converted will continue to grow on a tax deferred basis, but when withdrawn after the age of 59 1/2, the entire account will be tax free.

Various Income Limitations

The primary reason that every investor does not take advantage of the Roth IRA conversion is that there are income limitations. In order to convert a qualified plan or Traditional IRA into a Roth IRA, the account owner must not have an adjusted gross income of over $100,000 in the same tax year. This income limitation applies to both single tax filers and married tax filers. If an individual is eligible to convert their qualified plan or Traditional IRA into a Roth IRA, they will be required to pay income taxes on the gains realized as a result of the conversion. But, the 10% penalty for early withdrawal is not applied. If the taxes paid on the conversion today are less than the tax savings that will be received upon the withdrawal of Roth IRA funds in the future, it may make sense to convert the qualified plan or Traditional IRA. It is important to discuss these options with a financial professional prior to taking action.

How to Open a Roth IRA Account

Account Opening Introduction

Once you have made your decision to open a Roth IRA, you must select the financial institution in which to invest with. This decision can in many cases be the most challenging for an investor. Refer to the best Roth IRA providers for recommendations on where to open your Roth IRA.

Find a Financial Firm/Broker

If you are not currently working with a financial professional, you will want to locate a firm and an individual in which you feel comfortable. You can ask for referrals. You can talk with your local bank. If you have never worked with a financial firm or investment advisor, it is advised to schedule appointments with several so that you can interview them and select the location and individual in which you feel the most comfortable with.

Ask Specific Questions

Once you have narrowed down your selections and scheduled interviews, there are several questions that you will want to ask of each person including:

  • What is the minimum account investment?
  • Do I need to make monthly contributions or can I make a single investment?
  • What are the account opening fees and maintenance fees?
  • What can I invest in within my Roth IRA?
  • How will I receive my statements?

Open Your Roth IRA Account

Once you have decided where you are going to open the account, you will need to provide the financial firm with detailed personal and financial information. Some typical information that will be requested includes:

  • Your social security number
  • Your employment information
  • Your driver’s license or other picture identification
  • Your opening deposit amount in the form of a check or money order, and in some cases they will accept an account transfer form

You will be able to open your Roth IRA account using a money order or cashier’s check, personal check, registered securities that are properly endorsed, through a Roth IRA conversion or through an account transfer at another financial institution.

How to Choose Investments for Your Roth IRA

Choose Between a Wide Variety of Investments

Once you have opened a Roth IRA, you will need to select investments for your new account. You can invest in virtually anything within your Roth IRA account, including mutual funds, individual securities, bonds, ETFs, money market funds, CDs, and real estate investment trusts.

Identify Your Risk Tolerance

Before you select investments to place within your Roth IRA, you need to determine what your personal risk tolerance is with regards to investing. Risk Tolerance simply refers to the amount of risk that you are willing to accept within your portfolio to achieve a specific level of investment return. And, most investors will change their risk tolerance over time, becoming more conservative as they age as their interests tend to turn more towards capital preservation. Consider the following risk tolerances to see where you fall:

  • Aggressive – An aggressive investor is typically someone who is looking to outperform the standard rates of return experienced in the stock markets. On average, an aggressive investor is someone who is targeting a rate of return above 11-12% per year. The ideal time frame of this type of investor is greater than 10 years, as this will allow enough time for a portfolio to rebound in the event of a decline.
  • Moderately Aggressive – A moderately aggressive investor is someone who typically has an investment time frame of between 7-10 years, and who is looking for capital appreciation in their portfolio. The target annual rate of return for this investor’s portfolio is typically 10%.
  • Moderate to Moderately Conservative – A moderately conservative investor is someone who is targeting an annual rate of return of between 5-7% and who generally has between 5-7 years before they will need to access the funds. This type of investor is hoping for some capital appreciation but is likely focused more on the preservation of their capital.
  • Conservative – A conservative investor is someone who is focused on capital preservation of assets and often on receiving current investment income. The average investment time frame for a conservative investor is typically 1-3 years.

Once you have determined which type of investor you are, you will need to determine what the proper asset allocation is for your investment portfolio

Choose Your Asset Allocation

Asset allocation refers to the types of investments and the investment balance for an individual portfolio. The premise behind the concept of asset allocation is that there is a maximum level of return than an investor can receive for any given level or risk that they take. For example, a conservative investor is not likely going to achieve rates of return of 10% on an annualized basis. When working with the asset allocation model, there are 22 different types of asset classes that an investor could consider holding within their portfolios. Some of these asset classes include:

  • Large cap, mid-cap and small cap stocks
  • International stocks
  • Municipal bonds
  • Investment grade bonds
  • High yield bonds
  • Real estate

Investors can allocate their portfolio into any combination of the 22 asset classes based upon their personal risk tolerances and the amount invested. Also, investors can elect to invest into individual securities within these asset classes or into mutual funds. A mutual fund is generally the recommended method of investing for new investors as they offer additional diversification within the portfolio, professional management and often have a lower initial investment amount required. Mutual funds can be purchased with front end fees, larger annual management fees or with back ended withdrawal fees. Each type of mutual fund offers advantages and disadvantages and were designed to work with a variety of investor types. Discuss your investment needs with your financial advisor and they will be able to tell you which type of mutual fund share classes are best for you. Once you have decided which type of investment or portfolio you would like to leverage, you will need to decide how you would like to invest. While most financial companies and accounts will require a minimum opening deposit, most will also be able to establish a monthly automatic savings program. If this is your first Roth IRA, consider, in addition to your initial investment, setting up a monthly bank authorization via your checking or savings account to fund your Roth IRA for the next tax year and every tax year moving forward.

The Autopilot Roth IRA Portfolio

Now that you know how important asset allocation is, you can maximize your investment returns on autopilot using the Gone Fishing Portfolio. In 1990, Dr. Harold Markowitz won a nobel prize in Economics for his discovery of the underlying math behind the successful Gone Fishing Portfolio. Since its inception, the Gone Fishing Portfolio has compounded at 17.3% per year. It consistently outperforms the S & P 500 even though it is much easier than most active mutual funds. Best of all, it only takes 30 minutes per year to setup and manage! The Gone Fishin’ Portfolio

  • Vanguard Total Stock Market Index (VTSMX) – 15%
  • Vanguard Small-Cap Index (NAESX) – 15%
  • Vanguard European Stock Index (VEURX) – 10%
  • Vanguard Pacific Stock Index (VPACX) – 10%
  • Vanguard Emerging Markets Index (VEIEX) – 10%
  • Vanguard Short-term Bond Index (VFSTX) – 10%
  • Vanguard High-Yield Corporates Fund (VWEHX) – 10%
  • Vanguard Inflation-Protected Securities Fund (VIPSX) – 10%
  • Vanguard REIT Index (VGSIX) – 5%
  • Vanguard Precious Metals Fund (VGPMX) – 5%

Vanguard is the mutual fund company of choice because of its quality mix of securities and low expense ratios. The above portfolio can be replicated across many other mutual fund companies with the help of a financial advisor.

How to Maximize Your Long Term Roth IRA Benefits

Be Consistent

In order to get the most of your investments, you will have to accomplish two key habits that most investors miss: consistency and patience. You must be consistent with your Roth IRA contributions, and committed to maxing out your Roth IRA account before the deadline each year. This will give the retirement funds the best chance to grow over the long term.

Be Disciplined

You must also be disciplined and avoid withdrawing your Roth IRA funds for spending purposes. Too many smart people have withdrawn IRA account funds and uttered these very words, “I’m only borrowing the money to pay bills. I will put it back in no time.” The sad reality is that there is no time left. You cannot make up missed or withdrawn contributions by sending more money to your Roth IRA. Once you withdraw any money, that amount is lost forever so take as many preventive measures as possible to avoid withdrawing retirement money.

Start Living Life to the Fullest

Why wait til retirement to began living life to the fullest? Start now. Start today. Your Roth IRA money is strictly for your retirement, but there are many low cost ways to reward yourself with mini-retirements to make your life much more enjoyable. Timothy Ferris, author of the Wall Street Journal best seller The 4 Hour WorkWeek, wrote his book specifically for employees who wish to live the life of their dreams. His strongest message is to stop waiting for 1 vacation a year to start living life on your terms. The same goes for your retirement. Start doing the things you enjoy every day so when you finally retire, you don’t miss a beat. When you retire, your portfolio will generate income on autopilot, the tax man can’t take a dime, and you will spend every hour of every day doing exactly what you love to do. It’s the perfect scenario, and is simple to achieve with the Roth IRA.

Recommended Roth IRA Resources

Books

  1. The Gospel of Roth
  2. The Roth Revolution

Best Roth IRA Brokers

  1. Tradeking
  2. Zecco
  3. OptionsXpress
  4. Etrade
  5. Fidelity

Websites

  1. IRS Retirement Guide
  2. About.com Retirement Section
  3. Investopedia.com Retirement Directory