Business - Business Headlines

Sunday, Nov. 08, 2009

Clearing up misconceptions about Roth IRAs

Comments (0) |

Question: I'm 23 and have been making a point of saving money in a savings account. I've been told that a savings account isn't good for my future and that I should invest in a Roth instead. But I don't want to choose anything risky. Would I lose money if I invest in a Roth?

Answer: Your question suggests that you have a common misconception about Roth individual retirement accounts.

Many people think a Roth IRA is an investment like a stock, and so they imagine making money or losing money based on that particular investment. But a Roth IRA is simply a place to put your money.

Once you put money into a Roth IRA, you have to decide how to invest it. That's the decision that determines how much risk you will take, and how much money you may make or lose.

Say you have $1,000 to save for retirement. You could put it in a bank savings account, or you could go to a bank, a brokerage firm or a mutual fund company and open a Roth IRA.

A Roth would be an excellent choice, because once you put money into one, it is not taxed if you follow certain rules. If you're familiar with a regular IRA, a Roth is different. With a Roth, you pay taxes on the money you contribute, but not when it is withdrawn or on the amount it has earned.

That tax break allows your money to potentially grow faster than in a traditional savings account, which is taxed each year.

Your money can sit in a Roth IRA for years. But it won't grow until you decide how to invest it.

You will have a few choices. If you want to be safe, you could invest the $1,000 into an FDIC-insured bank certificate of deposit. But this choice would make very little money, perhaps 2 percent a year.

If you wanted to make more money over a decade or two, you might choose a stock mutual fund. With this fund, you would, in effect, hire a professional to look at stocks available in the market and choose some for you.

In years like last year, when the benchmark Standard & Poor's 500 index dropped 38 percent, you could lose a good chunk of your savings. But over many years, you would probably make more than you would in a CD. Since 1926, investors have gained 9.4 percent a year on average in the stock market despite some awful losing spells.

Other choices could include bonds, individual stocks or bond mutual funds that employ a professional to choose a variety of bonds. You could divide the money multiple ways to enhance earnings potential while cutting risks.

If you are nervous about the stock market but like the idea of trying to make more money than you could in CDs alone, you could put $500 in a CD or a bond mutual fund. You could put the other $500 into a stock mutual fund.

Or you could put the full $1,000 into a balanced mutual fund that invests roughly 60 percent of your savings in stocks and 40 percent in bonds. Last year, such a fund would have lost about 20 percent instead of 38 percent in the stock market, and this year you would have regained much of that.

Individual stocks would be the riskiest choice because it's more difficult to pick winners than if you invest in many stocks through a mutual fund.

That said, it's sometimes difficult for beginners to find places to start investing with $1,000 or less. One place that does is the T. Rowe Price mutual fund company. The firm will allow you to open a Roth IRA as long as you invest $50 each month into mutual funds. Consider a target date fund with the year 2050 in it. That is designed to pick a mixture of stocks and bonds for people in their 20s.

This would not be appropriate, however, if you are saving to go to college or buy a house within five years. When you have just a few years to save, the chance of losses makes stocks less attractive.

If that is your intent, keeping your money in CDs in a bank might be the best approach. If you aren't sure about your goals, you could use a Roth and invest safely in CDs. Under the rules for Roth IRAs, you can remove anything you deposit at any time as long as you leave the interest you have earned in the account until age 59 1/2. If you need money earlier for college or a home, the government lets you do it without penalty.

ABOUT THE WRITER

Gail MarksJarvis is a personal finance columnist for the Chicago Tribune and author of "Saving for Retirement Without Living Like a Pauper or Winning the Lottery." Readers may send her e-mail at gmarksjarvis@tribune.com.