If you're like most investors, you probably sock away money in a 401(k) through your employer. But you may not know that there's an additional vehicle available to you to save more money for retirement. The Roth IRA is available to almost everyone, and it offers great benefits for long-term financial planning.
Put simply, the Roth is a fantastic way to compound your wealth over time. If you're looking for an additional account to build your retirement nest egg, here's why you should open a Roth IRA right now. I also have a few investment ideas for you once you've opened it.
Why everyone should have a Roth
There are two types of individual retirement accounts, or IRAs, at your disposal: the traditional IRA and the Roth IRA. There are some fundamental differences between the two.
With a traditional IRA, your contributions are tax-deductible. Not so with a Roth. However, the trade-off is that your eventual withdrawals from a Roth IRA are tax-free, so you keep every penny of your final account balance. In addition, you can withdraw your contributions (but not your portfolio's earnings) from a Roth at any time without penalty.
Another difference pertains to distributions. With a traditional IRA, you must begin taking minimum distributions starting at age 70-1/2, whereas you are never required to withdraw your funds from a Roth.
Not everyone is eligible for a Roth, however. In 2014, single filers can make a full contribution provided their income does not exceed $114,000. The income limit for joint tax filers is $181,000. However, you are only allowed to make a partial contribution if your household income falls between $181,000 and $191,000. If your income is higher than that, you'll have to go with a Traditional IRA.
The reason a Roth is the best choice for many is that it allows tax-free growth of earnings and dividends forever. Specifically, younger investors and individuals who believe their income will be higher later on than it is right now benefit the most. Investors who have a long investing time horizon can receive the full benefit of years of tax-free compounding, and for most people, it makes more sense to incur the tax burden now rather than later, when they'll likely be in a higher tax bracket.
For example, a 25 year-old who puts away $5,500 in 2014, the maximum contribution for this year, will see that grow to more than $182,000 when he or she turns 70 and a half, assuming an 8% annual return. That is the age that person would need to make a required minimum distribution if that money was in a Traditional IRA. This shows the power of compounding growth, and with a Roth, you're free to let that money grow even further without having to make a distribution.
To that end, here are some great options for a Roth IRA.
Go for dividends
Tax-free growth is especially advantageous when your investments pay dividends. If you hold stocks in a taxable account, your dividends will be taxed each and every year. Holding great dividend-paying stocks in a Roth IRA will allow you to grow your wealth for years without forking over a portion of the dividend in taxes.
Stalwarts like Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG), which pay healthy dividend yields of 2.8% and 3.2%, respectively, are two good examples. Both companies pay solid dividend yields, and they raise their dividends like clockwork every year. That means you are taking even greater advantage of their compounding power by holding these stocks in a Roth IRA. Earlier this year, P&G increased its dividend by 7%, representing the 58th consecutive year of a dividend bump. In all, P&G has paid dividends for 124 years in a row. J&J also raised its dividend this year by 6%, marking its 52nd year in a row of a dividend increase.
The Foolish takeaway
The bottom line is that a Roth IRA is a great tool for long-term financial planning. Younger investors will particularly benefit from the ability to grow wealth tax-free for decades. If you're looking for a place, in addition to your 401(k), to sock away extra cash for retirement, the Roth IRA is a great choice.
Once you've opened a Roth, dividend-paying stocks are a great investment because of the huge benefits of tax-free compounding interest. Do your future self a huge favor by opening a Roth IRA today if you don't already have one.