2011 Roth IRA Guide
I want to congratulate you on taking the time to invest in your future by learning more about the simple yet powerful Roth IRA account. When you invest in a Roth IRA account, you’re investing in the privilege to retire on a stable and consistent monthly income, spend your free time doing the things you love, and spend more time with your friends and family.
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.
Different Types of IRAs
There are two primary types of IRAs, the Roth IRA and the Traditional IRA. With a traditional IRA, the funds that are invested are potentially tax deductible to the account owner, similar in nature to a 401(k) through an employer. The money taken out of a Traditional IRA at retirement is taxed at the account owner’s individual or joint tax rate.
On the flip side, the money invested into a Roth IRA is not tax-deductible. The funds placed in a Roth IRA are however withdrawn tax free in retirement, including the account’s gains, providing a huge incentive for investors who are looking to reduce their taxable income in retirement. So, to summarize, Traditional IRA’s are taxed on the backend, while Roth IRA’s are taxed on the front end.
Roth IRA Rules
Not every investor can take advantage of the Roth IRA; there are income limitations placed upon the investors who wish to contribute funds into this type of account. These limitations are established by the IRS and change on a year to year basis. Currently, a single individual with an adjusted gross income (AGI) of more than $95,000 is prohibited to contribute funds into a Roth IRA account.
For a couple, the AGI is $150,000. These limitations change on a annual basis, so be sure to check with your tax advisor or financial advisor with regards to your eligibility prior to making a contribution. If you are over the age of 50, the IRS has established a catch up provision for those who are eligible to contribute into a Roth IRA.
The catch up provision allows individuals who are 50 or older to make an added contribution into their Roth IRA accounts to help them prepare for their retirement, or in some cases, to catch up in the amount of money that they need set aside to comfortably retire. There are some important Roth IRA rules and facts to become familiar with in addition to the AGI restrictions, including:
- The person contributing funds into a Roth IRA must have earned income for the tax year that they are making a contribution.
- The Roth IRA contribution must be made prior to the current year’s tax deadline of April 15th for the prior year’s Roth IRA account.
- Roth IRA account dividends and distributions are not counted against the total amount allowed to save into the Roth IRA account each year.
- The Roth IRA contributions can be withdrawn at any time without a penalty. But, if the account earnings are withdrawn prior to the age of 59 ½, they are subject to both an early withdrawal penalty and taxes. There are a few exceptions to this rule which should be evaluated prior to making a withdrawal.
There is a first home purchase provision allowing first time homeowners to withdrawal $10,000 to buy their first home, including both contribution and earnings, without penalty.
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.
Traditional IRA vs. Roth IRA
Roth IRA Contribution Limits
Now that you have the basics down with regards to the Roth IRA, it is important to also become familiar with the differences between the Roth IRA and the Traditional IRA. Each investment account type offers the investor advantages and disadvantages that must be taken into consideration when selecting the best one to utilize. Both the Traditional IRA and the Roth IRA have annual contribution limitations as well as catch up provisions for investors who are over the age of 50. It is advised to discuss these with your tax advisor or to visit the IRS website prior to making an investment.
Deductibility
The contributions to a Roth IRA account are never tax deductible, while in some cases depending on the income of the person who is contributing, they are deductible for the Traditional IRA.
Income Restrictions
There are annual income restrictions for contributions made to the Roth IRA. There are not income restrictions for contributions to a Traditional IRA, but there are restrictions for the amount if any of the contributions made that are tax deductible.
Account Earnings
The earnings of both accounts grow tax deferred until the funds are withdrawn. When funds are taken out of a Roth IRA after the age of 59 ½, they are in most cases free of state or federal income taxation. Traditional IRA funds withdrawn after the age of 59 ½ are taxed at the account owner’s ordinary income tax rate.
Required Minimum Distribution Rule
This rule does not apply to Roth IRA accounts, but the beneficiary of these accounts are subject to this rule. The funds within a Traditional IRA are subject to this rule, requiring the account owner to take withdrawals after the age of 70 ½.
Why Choose Roth IRA over Traditional IRA
Roth IRA vs. Traditional IRA Graph
The graphic above shows why opening a Roth IRA account will save you more money for retirement than the Traditional IRA. In the example above, the calculator set to the following parameters:
- Age: 35
- Rate of Return: 8%
- Annual Contributions: $4,000 per year
- Tax rate: 30%
- Retirement age: 66
- Annual Gross Income: $80,000
- Retirement Tax Rate: 25%
At the age of 66, you would have either:
- $688,000 if you invested with a Roth IRA account or
- $558,000 if you invested with a Traditional IRA account
The key difference is the tax savings. Since all Roth IRA contributions are pre-taxed, you save all those tax dollars in the future when you withdraw those funds. On the other hand, the Traditional IRA account is extremely tax-inefficient, and will cost you hundreds of thousands of dollars due to its after-tax qualities. For most families, Roth IRA accounts are the best way to save for retirement.
Roth IRA Calculators
You’ll need to use a roth ira calculator to figure out how much you should save each year.
Here’s a list of the best Roth IRA calculators:
- Roth IRA Calculator -http://www.your-roth-ira.com/roth-ira-calculator.html
- TIAA CREF – https://www3.tiaa-ref.org/iracalcs/conversion_calc.jsp
- Roth IRA Savings Calculator -http://www.dinkytown.net/java/RothIRA.html
- PlanningTips.Com Roth IRA Calculator -http://www.planningtips.com/cgi-bin/roth.pl
- Roth IRA Comparison Calculator -http://www.moneychimp.com/articles/rothira/rothcalc.htm
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.
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. You can also research in the Yellow Pages or online to locate a list of potential options. 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.
