What's a Roth IRA invested in?

[Guest BonnScott]

What does a Roth IRA invest in? Does it invest in mutual funds? Can I set up a Roth to invest in an index fund? Or am I way off here? Thanks for any help.

[papogi]

A Roth IRA is only a title given to an investment when it is set up a certain way. Say, for example, you go to your local bank and buy a 1-year CD. At the end of the year, you have some taxable interest to report on your taxes. If, however, you tell the bank when you are buying the CD that this is going to be a Roth IRA, they will have a different set of forms for you to fill out (or another box to check on your application, and a place to name beneficiaries). In this case, at the end of the year, you have the interest the CD earned, but that interest is not reported on your taxes. A Roth IRA is a title you give to almost any (not all, there are exclusions) investment, and is basically an agreement between you and the IRS. If an investment is set up as a Roth IRA, any earnings and growth on that investment are not taxable. That’s what you gain. However, the price you pay for that are the restrictions that come with a Roth IRA (e.g., you can only contribute a certain amount each year, you can generally only begin to take money out of it after age 59 ½, and if you take money out before that, you may have a penalty and maybe income tax to pay). Custodians typically charge a small annual maintenance fee ($10 or $15), but this varies, sometimes is not charged at all by some custodians, and often is phased out once accounts reach a certain dollar threshold. A Roth IRA is not designed as a short-term investment device. So, yes, you can invest in mutual funds, index funds or not. You can invest in individual stocks, money market funds, or even open a regular savings account at a bank. All of these can be designated a regular taxable account, or a Roth IRA if you choose. When you buy the fund, you’ll need to tell the custodian (the ones offering the fund) that you would like this to be a Roth IRA. You’ll see no-load, well-diversified mutual funds touted here, and I also subscribe to that, especially for beginners. The Vanguard group of mutual funds is a good place to start, and maybe a good place to stop, as well. Ask for some of their educational material. Just remember that the performance of a Roth IRA is dependent upon the performance of the underlying investment. A Roth IRA doesn’t perform at all, good or bad. It’s the investment vehicle underneath that dictates its volatility, whether it’s going up or down, and by how much.

[John G]

Basic questions are just fine.

IRAs and Roths tend to be self directed investments. You make the decision. Your first two decisions are "who will be my custodian" and "what kind of investments fit my circumstances". Custodian choices include banks, mutual funds and brokerages. You often get access to some mutual funds at all three locations.

When you are just getting started, a NO LOAD (no front or exit commission) mutual fund is a reasonable choice because you buy in dollar increments (rarther than 100 share blocks) and get some immediate diversificiation (owning a wide range of investments). An Index fund gives you market performance at ultra low cost - even no load funds have imbedded annual expenses and for index funds this is often below 2/10ths of a percent. Index funds are a little easier to monitor. You can keep things fairly simple for a long time and get good results. Over the long haul, an investor generally does not need to "beat the market" to achieve their retirement goals.

Here are some discussions that have occured at this site previously on this topic:

http://www.benefitslink.com/boards/index.p...=6565&hl=novice

http://www.benefitslink.com/boards/index.p...778&hl=beginner

http://www.benefitslink.com/boards/index.p...876&hl=beginner

http://www.benefitslink.com/boards/index.p...350&hl=beginner

http://www.benefitslink.com/boards/index.p...523&hl=beginner

Note to new readers - you can often find information on this message board by using the search options at the bottom of the page. It is OK to repeat a question, especially if your facts or circumstances are a little different. If the answer seems to be off the mark, or generates more questions.... post again!

[John G]

Papogi, you type faster than me apparently. Good post.

To clarify the withdrawal part - contributions to a Roth can be withdrawn without any tax consequence. There are also exceptions for home buying and education expenses. But a Roth is a great tax shelter and I would be extremely reluctant to withdraw for these purposes when home equity loans and other borrowings have such low rates.

[Guest BonnScott]

Thanks everyone.

[dh003i]

A basic overview of the Roth:

• Contribute up to $3,000 in 2003. Scheduled to increase to $4,000, then $5,000...thereafter to be adjusted according to inflation in $500 increments.
  
• Contributions are not tax-deductable. However, you may be able to obtain a tax-credit for contributions. It will show up as the Retirement Savings Credit on your 1080.
  
• Contributions can be withdrawn at any time, completely tax-free (because you've already paid taxes on them). Earnings can be withdrawn completely tax-free once you're 59.5. Thus, you get to keep all of the money you earned.
  
• All things equal, it is for the most part hands-down a better choice than a Traditional IRA, because earnings are not taxed at all. However, a 403(b) or 401(k) is a better first option in so-far as you invest as much as is needed to max-out employer contributions.
  
• The assets in your RothIRA may or may not be protected from court-rules and the claims of creditors. It depends on your state. Talk to an attorney.
  
• A fringe benefit: RothIRA's and other retirement vehicles can help you stay out of debt. For most people, spending -- and debt -- rises in proportion to their earned income. Which means that as they earn more and more money, they find more and more "creative" (e.g., useless) ways to waste it. Putting aside a certain portion of money makes you see less money, which means your spending -- and thus, probably your debt -- is reduced.
  
• There are very few restrictions on what you can invest in. One thing, however, that you can't invest in is life-insurance (a bad investment anyways, for most people).