More on ROTH IRA

[Guest jkriv03]

ive always been curious about retirement and setting myself up. I actually stumbled onto an older article that caught my attention. You guys were talking about investing in the S&P(index) fund. Do you feel that this article is accurate? Would this be the S&P you are talking about?

Q. Awhile ago, you mentioned an IRA that was good for young people. My daughter is 18 and would like to open the IRA with her summer earnings. What was it?

— D.W., Woodbury

A.

It's a Roth IRA — a dream come true for a young person's future.

Once your daughter puts her money into a Roth IRA, she will never have to pay a penny in taxes on the money if she follows the rules. That means it can grow much more effectively than any other account, and especially better than a bank savings account. And as long as your daughter doesn't remove the earnings until she's 59½, she won't have to share a cent with Uncle Sam.

If your daughter starts investing money at age 18 and contributes about $2,000 a year throughout her working years, she can become a millionaire if the stock market acts like it has historically.

But to get there, she will need to invest in the stock market. The easiest way is to invest the Roth IRA money in what's called a total stock market index fund.

If she does that, she will own a tiny, tiny piece of about 5,000 different stocks that will be in her mutual fund.

Tell her not to pay attention to her fund if the market goes down for a while. There have been years when the market has gone down 50 percent. But over time, it recovers, because the U.S. economy keeps growing. If a person had put $1 into the stock market in 1925, it would have grown to $2,533 at the end of 2004.

The key is to find an index fund that will accept your daughter as a client. If she can invest $1,000, she can open a Roth IRA at one of the lowest-cost mutual fund companies, Vanguard (1-800-997-2798), and invest in the Vanguard Total Stock Market Index fund. Keeping costs down is a tremendous plus in the long run. It can leave her with almost twice the nest egg after a lifetime of investing as she would have with a high-cost fund.

Another attractive choice would be T. Rowe Price Total Equity Market Index (1-800-638-5660). The firm will allow an investor to open a Roth IRA with no money, as long as she will commit to investing $50 automatically each month.

If your daughter doesn't have $1,000 or the ability to invest $50 monthly, there are hundreds of other choices. She can open a Roth IRA at a bank, for example, and deposit small amounts of money. But beware of mutual funds at banks. Many charge you loads, or large sales charges. And the bank mutual funds often are expensive day in and day out, too.

If your daughter puts money in an index fund, the broker at the bank should not charge a load either up front or years later. And the "expense ratio," or what she will pay for the privilege of using the fund, should be no more than 0.50 percent of the assets she will have in the fund.

Vanguard, for example, charges only 0.18 percent for its total stock market fund, which is an excellent price. T. Rowe Price charges 0.40 percent — still good, but not as good. But it beats the 1.5 percent charged by the average mutual fund.

Now that I've given you the warning on fees, however, let me backtrack just a little. If you can't get into a low-cost fund at a place like Vanguard, and think you should give up, don't do that. A fund that charges 1.5 percent in fees is better than not investing at all.

Just wanting additional input.

[John G]

Most of the facts are correct and the general direction of the article is accurate. Nothing "dreamy" about a Roth, it is a bread and butter approach to building long term wealth open to all folks who work. Yes, you can open a Roth IRA for a teenager if they have earned income... I did that many years ago for my kids. You can even fund the account for your daughter - it does not have to be her money. Yes, she can become a millionaire if she continues to fund her Roth and makes reasonable investment returns over many decades. And, Yes, Roth withdrawals are tax free.

Some fine tuning on the points made:

1. Current maximum contribution for either 2005 (its not too late for 2005, you have till tax filing date in April) or 2006 is lower of $ 4,000 or her earned income. The 2k they talked about was the max amount for IRAs many years ago and so you still find many examples using that number.

2. The article misleads you on the wait to 59 1/2 for withdrawals. You can actually take out contributions at any time without penalty or tax. You just can't prematurely dip into accumulated earnings unless for a few allowed special uses.

3. You mentioned the S&P500 index fund. The article talks about a total market index fund of 5,000 stocks. There is a difference. The S&P500 is based upon Standard and Poors list of 500 very big companies. The total market includes the S&P500 list (I think there is total overlap) but extends the list to include another 4,500 large and mid size companies. Index fund means a mutual fund that uses a computer to buy stocks based upon a list, rather than hiring analysts to scutinize companies and perhaps visit firms. Historically index funds have provided good returns because of the ultra low annual expenses. You can search the term "index" and find pro/con arguments in prior posts. You can find the list of companies via a Google search!

4. T Rowe and Vanguard are respectable sources for many different kinds of funds. Vanguard created the index fund concept and prodded other mutual fund families to offer similiar products. There may be as many as 10,000 mutual funds to choose from. NO LOAD funds do not have front or back end commisions. Most index funds are no load.

5. Comments about bank sponsored mutual funds are sometimes true. Banks used to focus on just commissioned based funds, often with high annual expense. Market forces are slowly getting more banks to offer better products... but buyer beware. Ask lots of questions about loads, expenses and fees. Read the prospectus before you send money to anyone.

6. A monthly checking account withdrawal plan is a reasonable way to start a Roth.

Hope this helps. You might want to offer a "match" with your daughter as an incentive to invest. Do take this opportunity to get her involved in understanding about investing. Nothing like looking at your account twice a year and seeing the nest egg grow. Don't do all the work for her - she needs to have some ownership in the process. Do understand that you run a risk that she will pull out all the money at some point to buy a car or go to Europe and you have no control over her account. We felt pretty confident that would not happen with our two daughters - "Dad would cut me off at the knees" I think my daughter once said.

[Guest FLMaster]

The problem with the roth is there is no deduction going in to the plan. Of course the funds accumulate tax free and the withdrawl is tax free...until the law changes...then what. Tax policy is subject to change without notice. Municipal bonds are tax free...or are they? Pension plans were estate tax free, then $100,000 tax free and now all subject to estate taxes. With huge deficits we must ask is Roth a plan or a trap for the unwary. Hope this is helpful.

[John G]

I think that prior paragraph is an awfully negative spin made from a few facts. You speculate a dark future for Roths. I think the contrary is more likely.

"Until the law changes..." ? It already has.

Congress has actually made IRAs better over the years. Then topped that by creating Roth IRAs. And then made some changes to improve Roths. I seem to recall that inheritance tax threshold has been moving up more or less. {If you want to complain about something, start with the AMT... and there is legislation pending on that which has some chance of passing.}

The budget deficit is a real problem, but manageable. A more important driver is that a number of policy wonks have suggested the US wean support entitlement programs like social security. Successful IRA/Roth participation takes some of the pressure off SSN.

Sure Congress can change the rules. But there is an army of Roth owners now. Taxing a Roth would be a major reneg. It would generate an immense amount of distrust in government. It would also go against some of the legal foundation of accounting. How many Congressman would survive a vote against Roths?

What is the most likely negative change to Roths? I am not sure. But I would be extremely surprised if existing account holders were not grandfathered.