Read This Before You Get a Roth IRA

By Selena

Many of our grandparents relied on pensions for retirement income, but few employers these days offer similar retirement coverage. Instead, we have a retirement tool that our grandparents didn't: the Roth IRA. It requires more discipline from us than a guaranteed pension does, but it's nevertheless a powerful tool for funding one's retirement.

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Roth IRAs were introduced as part of the Taxpayer Relief Act of 1997, with their most prominent feature being tax-free withdrawals in retirement. A Roth IRA can serve you well -- especially if you follow the rules and employ effective investment strategies.

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Roth IRA basics

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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 $75,000 and a $5,000 contribution? You'll only report $70,000 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 $75,000 and a $5,000 contribution? Your taxable income remains $75,000 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.

The contribution limit for all IRAs is the same for both the 2016 and 2017 tax years -- $5,500, plus an additional $1,000 for those 50 or older.

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Invest strategically in your Roth IRA

While 401(k)s often limit your investment choices to a modest suite of mutual funds, you can invest in all kinds of securities through your Roth IRA. Some make more sense than others, though. For example, it's not the best strategy to park municipal bonds in a Roth, since they're typically already tax-exempt. Low-interest-rate CDs and slow-growing stocks are also not ideal.

It can be effective to park Roth IRA money (at least some of it) in growth stocks -- especially if you're a long way from retirement. If a stock averages 15% growth per year for 25 years, a single $5,000 initial investment in it will turn into about $165,000. Better still, fully $160,000 of it will be a capital gain -- on which you pay no taxes, 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.

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Save aggressively in your Roth IRA

For best results with your Roth IRA, fill it to the brim each year. The more you park in it, the more dollars you'll have that will grow for you. Remember, too, that your earliest invested dollars can do the most for you, as they'll have the most time to grow and benefit from the law of compounding returns. Check out the following table, showing how much you could amass investing $4,500 or $5,500 each year:

Data source: calculations by author.

You can see how powerful time is by looking at how much more rapidly the sums grow in later years. Note, too, how much of a difference it can make to just invest an additional $1,000 each year. If you're old enough to contribute the $6,500 allowed for those 50 and older, aim to do so. And remember that contribution limits are increased every year or few years. By contributing as much as you can, you can build a bigger war chest for retirement.

It's hard to beat tax-free income in retirement -- and a strategically maximized Roth IRA can give you a lot of that. Couple Roth IRA income with Social Security benefits, and you can be well on your way to a comfortable retirement.

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