Should I open a Roth IRA?

[Guest Fa Fa Fo Hi]

So, as I was reading my Maxim magazine today, I stumbled upon a great article about Roth IRA's and how young kids should get into it and create an account. Something like puting just 100 dollars a month from the ages of 25 to 65 would make you a millionaire. Now, that raised an eyebrow.

Unlike the majority of people here, i'm just 21 years old. So i'm going to be starting young. To be honest, I my goal in life is to be secure and have my health; however, being a self-made millionaire would be great. Financially, my family is pretty well off, I attend a Big 10 University (Penn State) and want to open an IRA account.

Before I get judged, I know absolutely nothing about Roth IRA and would like any type of input. I have a steady job and make a pretty good pay for a 21 year old. Every 2 weeks I would like to put 100 into the account.

If somebody could teach me about this, it would be really greatful.

Thanks.

[Guest ctfudge07]

Hey, not so fast! Who says we're all a bunch of old farts here? Well, OK, I'm a half-old fart, so there you go.

100 time 26 = $2,600, which is great, but you can contribute (as of this year) up to $4,000 per year. Why not stretch and see if you can do that? Maybe you can do without some doo-dads and knick-knacks and other crap you don't really need to spend money on.

In any case, you have the right idea. Make it a lifelong habit. Contribute as much as you possibly can. Manage your investments half-decently (or better yet, do a great job!) and you'll be sittin' pretty someday. Plenty of us wish we had thought like you are thinking, but all we can do is work that much harder to try to make up for lost time. That's OK - some of us need extra motivation, anyway, and might have been lazy, mediocre investors, had we started way earlier.

Here's why I think a Roth is better than a traditional IRA (and why I've decided to open Roths only and max them out): The tempting tax deduction you can take with a traditional IRA is like letting the government in on your business, cutting them in on the deal. We all know that you have to pay taxes now or pay them later, but if you opt to pay them later, it's like the government will always own a little (or big!) part of your pile.

But if you just eat the tax now (make it a Roth rather than a traditional IRA, which I guess you've already figured out is the way to go), Uncle Sam will not be able to get his hot little hands in your money! You've paid him off and sent him on his way.

Sorry, I don't know what it is that you need to know - probably technical details, and I'm sure the smart and knowledgeable people here will step in and tell you whatever you need to know. You might have to ask more specific questions, though. Good luck!

[wsp]

I, too, would think that a ROTH would be a good fit but only because you're 1) young and 2) probably earning less now then you ever will in your life so your tax rate is low in comparison to when you'll be taking out your money. A large number of people actually will not benefit from a ROTH. And, a change to a 15% flat tax certainly will make everyone touting a ROTH look bad. Because it's long term benefit is unknown, I'm of the opinion that you shouldn't limit your contributions to one form or another. Better to diversify your taxable income just as you would your investments. Hedging your bets is the proper phrase.

At any rate, sounds like you really only need help in deciding where to start your ROTH contribution. First thing I would look into is if your employer has a 401k that you are eligible for and if that plan allows for ROTH contributions. If it does it could be that you just need to contribute there. Though I believe the 5 year window doesn't apply to rollovers out so you'll probably also want to start a ROTH IRA outside the plan too...not continually contribute but as seed money.

If your company doesn't offer one then you'll need to do the research on where you feel most comfortable putting your money. Some people prefer mutual funds, others prefer brokerage accounts. I'm not going to tell you which is better because it really does depend on individual circumstances.

Once you've decided where you want your money then look online...you may be able to fill out an application online. At the very least you'll be able to print one out to mail in. They'll be able to help you figure out the details as well. Find the 1-800 number and give them a call.

Good luck.

[John G]

Well, I may be age 55.... but heck, I too am a Penn Stater ('74)

Yes, a Roth is a fantastic vehicle for building wealth. Go for it. We are.... Roth State! (inside joke)

I also agree with the idea of stretching to put in the max 4k. Think of a few things bought on sale, a couple of cheaper substitutes, waiting a little longer for the next car, one less speeding ticket, buying off season, it doesn't take much. Especially when you are single and don't have those family/home obligations. Starting early is a big advantage - that 4k at 10% a yr grows to $265,000 when you are 65. The next 4K grows to $265,000 the following year. That's two max contributions putting you over 1/2 million - just those two early contributions. [you can do this kind of simple projection with a spreadsheet or the N/I/PV/PMT/FV functions of an HP 12c calculator]

Now, if you continue the 4K each year for 45 years... you get over the 3 million mark. Marry wisely - a spouse who also started her Roth at age 21 of course! - and you are building a $6 million nest egg. Remember those are future dollars, and inflation will not give you the same buying power, but that is still a lot of money. If your long term performance is a notch higher, it is not inconceivable that you might amass over $10 million. I don't remember anyone teaching this at PSU, maybe they should.

Moving on...

New topic - look also at your employer based plans. Some companies have 50% or even 100% matching contributions for participants in 401K.

New topic - I also hope along the way you write a few checks to PSU and Thon.** With success, I believe comes an obligation to what got you launched, and your community.

Good luck with your career.

John Grossmann '74 BArch

** THON is a student developed event at Penn State that has been raising funds for juvenile cancer treatment and family support for the past 34 years. It started as a dance marathon but has grown into a year round cause. Thon is the largest student organized philanthropic program in the world, raising over $4 million last year and involving thousands of students. A great way for students to be involved with their communities. Thon might even eclipse Joe Paterno some day as the first thing that people think about when you say Penn State... and he would probably like that.

See: http://www.thon.org/

PS: You might also want to pay $15 for an annual subscription to Kiplinger Financial magazine. It covers a lot of things like credit, home buying, starting your career, Roth/IRAs, vacations and solving financial issues.

[Belgarath]

You've been given a lot of good advice already, and if you listen to even half of it, you'll do very well indeed.

I'd like to put in one little observation about Roth IRA's which makes them even better, IMHO. (I'm a big fan of Roths) That is, the flexibility to withdraw your CONTRIBUTIONS without penalty. The Roth withdrawals are on a FIFO (first in first out) basis, so any withdrawal is considered to be a return of your contributions until your full contribution amounts have been withdrawn. Since it is hard to see too far ahead in life, this flexibility in an emergency, or to take advantage of some tremendous opportunity, can be a wonderful thing.

[John G]

Good point Belgarath.

I just noted the "flat tax" comment, which is mixing apples and oranges. "Flat" refers to a single tax rate rather than the current system of tiered rates. To know how a flat tax would impact households, you would have to resolve a second issue of what is defined as income and what if any deductions/exemptions might be allowed. Congress has long promoted a range of social goals (reduce taxes on the pour, tax "evils" like tobacco/whiskey, stimulate home ownership with deductions for mortgage interest) by very explicitly not having a flat tax. I recall hearing flat tax arguments many decades ago - its sort of a theoretical argument like are you safer or worse off in owning a gun. My personal view is that we are no where near inacting anything remotely like a flat tax. Ditto the value added tax. There is no universal agreement of the superiority of any of these approaches. I think its hard to make a dramatic change, partly because we live in a complex world and it is hard to get from point A to B.

Let's assume that a flat tax is passed. I doubt that it would ever be applied to Roth IRAs because households have pre-paid the taxes on a Roth, either at time of conversion or because after tax funds were used in contributions. Someone created the term "going postal" for folks who just went crazy as part of a highly routine job. What do you think would happen if Congress tried to tax a family twice on the same money?

Fa Fa - if you have questions about how to set up a Roth and make investment choices, do a keyword search on any of these terms on this site: beginner, novice, getting started, custodian, mutual funds, index funds, or Vanguard.

[Guest mjb]

Taxing roths is not going to happen b/c it would reduce revenue - people would stop contributing and would make contributons to tax deferred plans which would immediately reduce govt revenue. Flat tax, vat tax consumption tax, etc are non starters b/c they would tax people who pay little, if any income tax (bottom 40% of population) and would not raise as much revenue as the income tax. The only reasonable assumption is that income tax rates will rise at some time in the future and will be reduced aqt some time after the increase. E.g, 61 tax law reduced max rates from 91 to 70%, '81 tax law reduced max rate from 70 to 50%, in '86 max rate lowered to 28 %, in '90 max rate increased to 31%, '93 law increased max rate to 39.5%, in 2001 max rate lowered to 35%.

[John G]

Good points mjb.

When considering the impact on low income families, the income tax not neccesarily the driving factor. There are lots of other taxes and user fees (taxes under a different name). Excise taxes, tolls, licenses, recreation useage fees, real estate transaction taxes, property taxes, school district charges, vehicle taxes, gasoline taxes, sales taxes.... While lower income households pay either no or only a small percent in income taxes, all of these other taxes/fees are significant.

I don't think the 2010 conversion rules will stand unchanged. One reason Congress might not act is that the open season on conversions will produce a noticeable revenue increase in that year and they may want decide they want to extra revenue.

[Guest Fa Fa Fo Hi]

Thanks for the input guys, where would be the best place to get things started? Should I go to the bank, i'm assuming not. I'm just looking to the place where I can OPEN a roth IRA.

And for a Roth, is 4K a year max? I'll be geting my W2's back, and i'd love to just throw that entire iggy in.

And John, i've been in Thon for 2 years.

[John G]

Custodian choices: banks, mutual funds and brokerages are the big three

I would probably skip banks because they tend to offer conservative products like CDs or commission based mutual funds. At your age, the bulk of your assets should be in equities (aka stocks) and be best way to do that is via a NO LOAD mutual fund. No Load means a fund that does not have a front end or exit commission. There are thousands of no load funds.

Does that sound like I am steering you to a mutual fund custodian? Not really. Because you can get access to many mutual funds via modern discount brokers (Etrade, Scottrade, Fidelity, Schwab, TD Waterhouse... etc.).

Again - key word search on this web site for index, mutual fund, beginner, novice and started and you will find a lot of comments about choices.

Don't worry about a perfect choice - you can't find it in a year of searching and neither can I. You just need one good no load mutual fund to get started - a general fund covering the market. Avoid any sector, country, or otherwise narrowly defined fund. Stick with your fund for two years while you learn more. You can always switch later. Switch custodians, switch funds or switch both.

I highly recommend that you subscribe (about $15 per year) to Kiplinger Financial - a magazine that covers early career development, stock investing, IRAs, 401ks, home buying, debt/credit and a host of financially related issues for 20 and 30 somethings.

[John G]

Thon Update -

Unbelievable, Thon at Penn State raised $5.2 million this year, an increase of over $1 million over last year.

I have a lot of pride in PSU students for a monsterous amount of work - all year long. The benficiaries are

families with children struck by cancer.

http://live.psu.edu/story/22413

[Guest cjharrison]

Hey, not so fast! Who says we're all a bunch of old farts here? Well, OK, I'm a half-old fart, so there you go.

100 time 26 = $2,600, which is great, but you can contribute (as of this year) up to $4,000 per year. Why not stretch and see if you can do that? Maybe you can do without some doo-dads and knick-knacks and other crap you don't really need to spend money on.

In any case, you have the right idea. Make it a lifelong habit. Contribute as much as you possibly can. Manage your investments half-decently (or better yet, do a great job!) and you'll be sittin' pretty someday. Plenty of us wish we had thought like you are thinking, but all we can do is work that much harder to try to make up for lost time. That's OK - some of us need extra motivation, anyway, and might have been lazy, mediocre investors, had we started way earlier.

Here's why I think a Roth is better than a traditional IRA (and why I've decided to open Roths only and max them out): The tempting tax deduction you can take with a traditional IRA is like letting the government in on your business, cutting them in on the deal. We all know that you have to pay taxes now or pay them later, but if you opt to pay them later, it's like the government will always own a little (or big!) part of your pile.

But if you just eat the tax now (make it a Roth rather than a traditional IRA, which I guess you've already figured out is the way to go), Uncle Sam will not be able to get his hot little hands in your money! You've paid him off and sent him on his way.

Sorry, I don't know what it is that you need to know - probably technical details, and I'm sure the smart and knowledgeable people here will step in and tell you whatever you need to know. You might have to ask more specific questions, though. Good luck!

ctfudge07 couldn't be more wrong about "Sending Uncle Sam on his way." You still owe taxes at the time of withdrawal on the GAINS that your invoestment makes over the years. If you are eligible to contribute to a traditional IRA and you opt, instead, to contribute to a ROTH IRA, the only things you accomplish are 1) paying Uncle Sam taxes on your capital many years sooner than you had to and 2) thereby reducing your overall growth by reducing your amount of invested capital by the amount of the taxes that you pay on that capital contribution to your ROTH IRA.

So, if you are eligible for a traditional IRA (i.e. your company does not offer a 401k, 503b, etc. or you are unemployed or self employeed), that is your smart move. If you are not eligible, then contribute to a ROTH IRA.

[John G]

cjharison - I think the reference was to not paying Federal taxes on normal retirement dispursements from a Roth. Perhaps the language was a little sloppy, but I read it as referring to Roths and no taxes due on either contributions or earnings would be correct.

Your comment about one plan is superior to another is somewhat misleading and should not be offered as definitive guidance. The value of each retirement approach is significantly influenced by individual circumstances:

Income and filing status scenarios: future likely income, retirement income, marital status

Tax scenarios: current tax rate, future tax rate

Personal data: life expectance, long term goal, estate planning options

Employer plan issues: match (if any), portability, and investment options

Expectations about plans: current threshold limits and possible future restrictions/plans

Plan flexibility: control over distributions is a big one here

That is a big matrix of ovelapping considerations and requires a lot of "assumptions". Because many of the variables can not be accurately predicted, it is virtually impossible to say today what is the "best choice" for anyone.

You are correct to point out that there are tradeoffs between using after tax money (which means you paid the taxes now) vs paying the taxes later.

Company plans are often best with most of the following: good investment choices, portability when you leave that employer, and a good match.

Roths are generally best when the individual expects to be in much higher tax brackets in the future, the taxpayer wants control over dispursements, or wants to use the Roth as part of an inheritance plan.

IRAs are attractive when your current tax rate is high but you expect much lower tax rates in retirement.

(Note: If we could count on capital gains taxes being extremely low for decades to come, long term taxable stock accounts might beat out IRAs as your tax rate on "distributions" could be way below the tax rate on ordinary income. But hey, why complicate things with another scenario.)

Which approach works best may vary over your lifetime. Sometimes a combination or hybrid approach works... especially if the taxpayer wants to sock away a large amount each year.

[Guest ConsideringRoth]

I too, appreciate everyone's input.

But I am a little confused by what CJHarrison stated above...

"You still owe taxes at the time of withdrawal on the GAINS that your investment makes over the years."

Does this statement mean that i still have to pay taxes on the interest my Roth IRA earned over the years?

If so, my headache just returned.

[John G]

The prior posts had less than precise language. The quote does not apply to Roth IRAs.

Let me remove your headache: Current rules say no taxes on removing Roth contributions, and no taxes on "gains" (interest, capital gains, dividends, etc.) under the current Roth rules if taken after the retirement age. Further, there are no mandated distribution schedules on a Roth.

Taxation on conversions are similar, but have a few special rules. Conversion regs do not appear to apply to the problem you have stated.

PS: To all. Please read your posts carefully before making that final click. Look to see if someone might misunderstand the application. Avoid vague pronouns. Precise terminology avoids confusing folks. There are differences between contributory, rollover and conversions. Ditto Roth vs IRA. And "earned income" vs any income. IRS Publication 590 is not a lot of fun to read in part because the IRS (not they, but the IRS) tries very hard to include all of the conditions/caveats/exceptions.

[Guest ConsideringRoth]

Thank you John.

I initially asked the financial institution where i will likely go to open up the Roth, the same question (Will my contributions & interest be tax free after age 59 & 1/2)...

Much to my surprise, they said they cannot answer that question due to legal reasons, and suggested i ask my tax preparer.

I don't have a tax preparer because i prepare my own, but i did consult with one who confirmed that under current law, if i were to open a Roth now, there is no taxation on any withdrawals from the Roth at 59 & 1/2.

I was a little surprised though, that the financial institution could not answer that question. I realize they technically are not the ones taxing (or not taxing) me, but still, THAT is the whole reason a Roth IRA is desirable, and they couldn't talk about it.

[John G]

Banks, brokerages and mutual funds don't want to act as if they are offering legal advice. You asked a simple question, they could have answered, but perhaps someone was taking their internal guidance a little to seriously. (They also have brochures that layout the basics of Roths and IRA... but, hey, that's apparently not legal advice.)

Do pick up a copy of IRS Publication 590.

Good luck with your investments.