This year's tax-filing deadline has, thankfully, come and gone, but it's always a fine time to begin (or continue) fully funding a Roth for the 2007 tax year -- and beyond. Plain and simple, if you want to accelerate your road trip to financial freedom, you owe it to yourself to kick in as close to the maximum as you possibly can (assuming you are eligible) -- $5,000 if you are 50 or older this year and $4,000 for the "youngsters." Tax-free growth, after all, doesn't grow on trees.
Do the math
To get a clear sense of how much maxing out a Roth can matter, consider an investment of $4,000 plunked down on Vanguard 500 Index (VFINX), the battle-tested S&P tracker that counted AT&T (NYSE:T) and Wal-Mart (NYSE:WMT) among its top 20 holdings at the close of May.
Since its inception back in the bicentennial year of 1976 through the end of this May, Vanguard 500 delivered an annualized return of 12.4%. There's no guarantee that the fund will continue delivering at that pace, of course, so for the sake of our example, we'll assume 10.5%, the market's historical rate of return.
Crunching the numbers, we find that, for example, a 30-year-old investor who begins making an annual Roth contribution of $4,000 this year will wind up with more than $700,000 in her account when she hits 60. Our savvy investor won't have paid any taxes on the fund's distributions along the way, and when she begins drawing down the account after age 59 1/2, she won't owe Uncle Sam a dime, either.
Got your attention?
Sweet as the Roth deal is, there is some fine print you'll need to tend to. For starters, not everyone will qualify for a Roth, and those who do may face reduced contribution limits based on how much they earn. What's more, as I've pointed out, index funds aren't the best way to take advantage of a Roth's tax-fighting superpowers.
Among other things, you might want to consider reserving a Roth account for investments that generate income that would be taxable in a plain-vanilla account. On that front, Pfizer (NYSE:PFE) and Southern (NYSE:SO) are worth further research: Both boast yields that double up on the S&P's figure. Consolidated Edison (NYSE:ED) and Fifth Third Bancorp (NASDAQ:FITB) sport a similarly plump payout profiles.
The Foolish bottom line
If you'd like additional investment ideas and insight on how to put a Roth -- or any IRA for that matter -- to good money-making use, consider snagging a risk-free guest pass to Motley Fool Green Light, the Fool service designed with newbies in mind. In our April issue, we served up a list of tips to help you keep the tax man at bay this year and beyond. And in March, we presented a handy-dandy guide to which investments are best suited for tax-favored and taxable accounts.
Click here to get started. There's no obligation to subscribe.
This article was originally published on April 12, 2007. It has been updated.
Shannon Zimmerman runs point on the Fool's Champion Funds newsletter service and co-advises Motley Fool Green Light with his pal Dayana Yochim. At the time of publication, he didn't own any of the securities mentioned above. Wal-Mart and Pfizer are Inside Value recommendations. Southern is an Income Investor recommendation. You can check out the Fool's strict disclosure policy by clicking right here.
