IRAs were already very useful accounts for retirement savings when Roth versions of them were introduced as part of the Taxpayer Relief Act of 1997. The key feature of Roth IRAs can make a big difference in your retirement savings -- especially if you use the Roth in smart ways. Here are four Roth IRA investing tips that could earn you thousands of dollars.
First, though, let's review just what IRAs are, and how they work. For a wealth of in-depth resources on IRAs, you can visit our IRA Center. In the meantime, a quick overview.
There are two main kinds of IRAs -- the traditional IRA and the Roth IRA. With a traditional IRA, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes, too. (Taxable income of $70,000 and a $5,000 contribution? You'll only report $65,000 in taxable income for the year.) The money grows in your account and is taxed at your ordinary income-tax rate when you withdraw it in retirement.
With a Roth IRA, you contribute post-tax money that doesn't reduce your taxable income at all in the contribution year. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income remains $70,000 for the year.) Here's why the Roth IRA is a big deal, though: Your money grows in the account until you withdraw it in retirement -- tax free.
Note that Roth IRA contributions must be made with earned money. There's no minimum age for opening a Roth, but anyone funding their Roth IRA, whether child or adult, must do so with earned income. For kids, allowance or birthday money doesn't qualify, but cash earned through babysitting or odd jobs can. For adults, qualified earnings include wages, commissions, and even alimony payments, but not inheritances, Social Security benefits, or pension or disability income.
Now, let's get to those savings-boosting investing tips.
Tip No. 1: Be strategic about your Roth IRA investments
You can invest in all kinds of securities through your Roth IRA, but some make more sense than others. For example, it's not the best strategy to park municipal bonds in a Roth, because they're typically already tax-exempt. Low-interest-rate CDs and slow-growing stocks are also not ideal.
What's good for a Roth IRA? Well, consider parking in it those stocks you expect to be your fastest growers -- especially if you're a long way to retirement. If a stock averages 15% growth per year for 25 years, a $5,000 initial investment in it will turn into about $165,000, with that $160,000 of gain being tax-free if you withdraw it in line with the rules.
Real estate investment trusts (REITs) are also good for Roth IRAs. They tend to generate a lot of dividend income, but much or all of that is often not eligible for the low long-term capital gains tax rate, and is instead taxed at your ordinary income-tax rate.
In a Roth, there can be no tax at all. You can also do quite well just investing in a broad-market index fund or two, or a target-date fund, in your Roth IRA. Such a simple approach can be very effective.
Tip No. 2: Max out your Roth IRA
Next, be sure to invest all you can in your Roth IRA each year. You're limited as to how much you can contribute to an IRA -- or to several of them. Contribution limits (for all your IRAs together, not for each of them) are adjusted over time to keep up with changes in the cost of living. The limits for both the 2015 and 2016 tax years are the same: $5,500. There's also an extra $1,000 "catch-up" contribution permitted for those age 50 or older, letting those folks sock away as much as $6,500 for the year.
To get the most from your Roth IRA, fill it with as many dollars as possible. Sure, sending in $1,000 or even $3,000 to your IRA can help build a nest egg for retirement. But you can build a bigger and better one by maxing out your contributions.
For example, imagine that you contribute $4,500 every year for 25 years to an IRA, and it grows at 10% annually. That will grow to nearly $487,000 -- which is pretty good.
But if you contribute $5,500 annually (just $1,000 more), and it all grows at 10% per year, the end result will be $595,000 – a difference of $108,000! Of course, as the annual contribution limits rise each year, you should aim to keep contributing more, ending up with an even bigger nest egg.
Don't skip years, either. It's easy to think that a single missed year won't matter much, but if you made those $5,500 annual contributions for just 24 years instead of 25, you'd end up with $535,000 – about $60,000 less!
Tip No. 3: Be patient and stay the course
Great wealth is generally accumulated over time. So as you contribute to your Roth IRA, don't let fear or impatience derail your progress. If the market swoons, it's easy to panic, as so many do, and perhaps contribute less to your IRA, or skip a year of contributions, or sell some stocks in your IRA that have fallen in value even though they're likely to regain value.
Read up and learn enough about investing so that you're comfortable with the investments you've chosen, so that you know to expect occasional downturns in the market. The more you learn, the better choices you'll likely make, and the more your money will likely grow.
Tip No. 4: Consider converting other savings into Roth IRAs
Finally, if you have money in a traditional, not Roth, IRA, look into whether it makes sense to convert that IRA into a Roth. Doing so means you'll face a tax hit, as the money you're converting has avoided taxes so far, but will be going into an account funded with post-tax money.
You'll have to think about whether the tax hit is likely to be worth it. Conversions can make particular sense for younger people, whose Roth IRAs have very long growth periods ahead of them. They can also be smart to do during a market crash or correction, as the sum you're converting will be smaller.
If you're strategic about moves you make with your Roth IRA, you can accumulate even more in it -- and can set yourself up for tax-free withdrawals in retirement.