What is a Roth IRA?
The Roth IRA has become one the most popular retirement savings vehicles since its inception in 1998. Roth IRAs allow qualified individuals to make after-tax contributions, yearly, into an investment account which will grow at a tax free rate. Not only does it allow you to grow your money tax free; but if you adhere to the Roth IRA rules, you will be able to withdraw your money without paying a single dollar to Uncle Sam as well. This is the key difference between the Roth IRA and the traditional IRA.
The plan allows individuals to contribute after tax dollars into their Roth IRA account if they fall within the participation guidelines. For 2010, the maximum allowable Roth IRA contribution amount for qualified individuals is $5,000 if you are under the age of 50 and $6,000 if you are above. This amount is subject to change in order to adjust for inflation. Remember, this annual cap covers the aggregate contribution between a Roth and Traditional IRA, you cannot contribute $5,000 to each of them.
As opposed to 401k accounts, Roth IRAs provide individuals with a wide variety of investment options. These include stocks, options, CD’s, mutual funds, and even futures contracts. There are a few restrictions; for example, you cannot short a stock in a Roth IRA account as using margin is prohibited. However, the advent of inverse ETFs has made it possible for traders to speculate to the downside through their retirement accounts.
It is important that you understand that this retirement plan was created for long term wealth creation. If you anticipate having need for these funds in the short run (under 5 years) and before the age of 59.5, you will be responsible for penalties and all taxes associated to your investment gains. Your contributions can be withdrawn at any time, tax and penalty free. Additionally, there are income limits which will prevent some of you from participating in this plan. Visit our Roth IRA rules article to understand if you are eligible.
Where can I open a Roth IRA?
A wide variety of financial institutions will support a Roth IRA account. Banks, mutual fund companies, brokerage firms, and even insurance companies will allow you to create Roth IRAs with them. Picking the best provider depends on your investment objectives. For example, do you want the ultimate flexibility to configure your own portfolio and more actively manage it? Do you want to buy stocks, options, and/or mutual funds? If so, signing up with a leading brokerage company such as Fidelity, Scottrade or TDAmeritrade is a good bet.
FeesBe careful and understand the fee structure of these accounts before you open them. For example, if you plan to trade more actively, make sure there are no short-term trading fees.
Here is a list of a few fees that you should keep an eye out for: setup fees, account maintenance fees, low balance fees, short term trading fees, and account closing fees. Obviously, no fees are ideal but most companies will have a subset of the fees just listed. This is fine as long as you are aware of them and can make an informed decision. Unknown fees being deducted from your account can have a big effect in the long run, especially due to the loss of compounding. We will cover this in another lesson; however, remember that there are early withdrawal fees and taxes which can be imposed if you withdraw your money before you are allowed to. This is universal, no matter which provider you select.
You’ve just read through the basics of a Roth IRA. In the rest of our series; we will cover, IRA contributions, withdrawals, conversions, income limitations, and more.
Part 2 - Roth IRA Contribution >>
Part 3 - Roth IRA Conversion >>
Part 4 - Roth IRA Withdrawal >>
Part 5 - Distribution Ordering Rules >>
Part 6 - Recharacterization >>