We've all probably heard that we need to think about retirement, even from a young age.
We're told that we need to get a retirement account, and start saving – the earlier the better!
Have you ever wondered why you're better off if you start saving for your future earlier? It's the wonders of compound interest!
Compound interest is the eighth wonder of the world. He who understands it, earns it.. he who doesn't.. pays it.
– Albert Einstein
What Is Compound Interest?
Everyone knows that earning interest on your money is a great thing – but what are the different kinds of interest you can earn?
Simple interest: Simple interest charges interest only based on principle value; Let's say you lend $1000 to someone you know. If you lend it to them on a 5% rate per year on simple interest – that friend would owe you $50 each year before they pay you back.
Compound interest: Compounding interest charges interest on the principle value as well as the value of any interest previously accrued. So in the same example, if you charged your friend a 5% yearly compounding rate, he'd owe you $50 the first year, then 5% of $1050 the second year – $52.50 – (if no payments were made), and so on. The end result is that your friend would owe you increasingly more under compounding interest the longer it took for him to pay you back.
Here is the formula for calculating compound interest – from Wikipedia:
Where,
P = principal amount (initial investment)
r = annual nominal interest rate (as a decimal)
n = number of times the interest is compounded per year
t = number of years
A = amount after time t
So here's an example:
An amount of $1500.00 is deposited in a bank paying an annual interest rate of 4.3%, compounded quarterly. Find the balance after 6 years.
A. Using the formula above, with P = 1500, r = 4.3/100 = 0.043, n = 4, and t = 6:
So, the balance after 6 years is approximately $1,938.op.
Why Is Compound Interest So Great?
The reason why compound interest is so great is because not only do you earn interest on your principal balance, or the money you started with – but you also earn interest on your interest! If you are looking to grow wealth over a long period of time, compounding will definitely work in your favor and help you to achieve some exponential gains.
In fact, if you have a long enough time horizon and depending upon the interest rate, the money earned off of the interest alone can be greater than the principal invested at the start! See this chart for details:
Chart via thetaoofmakingmoney
Remember, however, that compound interest can work against you as well, so make sure that you're the one holding the reins, and like Einstein said, that you're earning it and not paying it.
What do you think about compound interest? Are you earning it or paying it? Tell us your thoughts in the comments!
Want to find out more about compound interest? Check out this great post and infographic about compound interest: Compound Interest Infographic.
The Roth IRA is an investment option that I love because of it allows your money to enjoy tax free growth and for the diversification it can bring to your tax situation at retirement. It can be great to have some tax free investments like the Roth in addition to pre-tax investment types like a 401k or IRA.
It's a good idea to try and put your money in, and never touch it until retirement so that you can enjoy the wonders of compounding interest, however, sometimes people run into situations where they'll need to do an IRA Withdrawal . Thankfully for those people the Roth IRA is an extremely flexible retirement account type and withdrawing the money you put in can be done tax and penalty free at any time.
Where you need to be wary is when you're considering taking an early distribution on your earnings before retirement age. If you aren't making a qualified distribution, you could end up paying not only your regular tax rate on the money, but a 10% early withdrawal penalty to boot.
Make A Roth IRA Withdrawal Of Contributions With No Penalties
One of the great things about the Roth IRA is that you can make a withdrawal of your principle balance/contributions at any time you please – without penalty. Where it gets a little stickier is when you try to withdraw the earnings off of your principle. The earnings can't be withdrawn without penalty until you reach the age of 59 1/2. Again, as mentioned above you can usually make a withdrawal of your principle contributions at any time. The earnings off of your principle can't be withdrawn until you reach the age of 59 1/2 or you'll end up paying a 10% early withdrawal penalty. You don't want to pay penalties now do you?
There is one situation in which you wouldn't be able to withdraw your earnings after 59 1/2 – it's when you have started the roth IRA within 5 years of when you turn 59 1/2. It's called the 5 year rule.
Roth IRA 5 Year Rule
You can only withdraw your earnings from your Roth IRA at 59 1/2 and have them count as qualified distributions if it has been at least 5 years since your Roth IRA account was opened. However, for example, if you opened your account at 57, you would need to wait until you were 62 to withdraw any earnings on your principle.
Qualified Reasons To Withdraw Roth IRA Earnings
There are a few situations where you can withdraw from a Roth IRA without taxes or penalties:
You are age 59½ or older. (see 5 year rule above)
The distribution was made to your beneficiary after your death. (you can't take it with you!)
You are using the money to buy a home, and are a first-time homebuyer ($10,000 lifetime maximum per account)
You're disabled.
Other Exceptions to 10% Penalty
Some people may find they need to withdraw money from their Roth IRA for a non-qualifying reason. They may still be able to get around the 10% early withdrawal penalty in these situations: (taxes will still be assessed)
You have un-reimbursed medical expenses that exceed 7.5% of your adjusted gross income.
You are paying medical insurance premiums after losing your job.
The distributions are not more than your qualified higher education expenses. (pay for schooling!)
The distribution is due to an IRS levy of the qualified plan.
The distribution is a qualified reservist distribution.
The distribution is a qualified disaster recovery assistance distribution.
The distribution is a qualified recovery assistance distribution.
Roth IRA Distributions Made In This Order
According to IRS publication 590 when you take your money out of your Roth IRA, the money comes out in this order.
Regular contributions.
Conversion and rollover contributions, on a first-in-first-out basis (generally, total conversions and rollovers from the earliest year first). Take these conversion and rollover contributions into account as follows:
Taxable portion (the amount required to be included in gross income because of the conversion or rollover) first, and then the
Nontaxable portion.
Earnings on contributions.
The distributions are done in such a way as to help you avoid paying taxes and penalties if at all possible. Your contributions to your account come out first, followed by rollover contributions and earnings on your contributions.
Try Not To Withdraw Until Retirement
Roth IRAs are great because they allow you to have flexibility when it comes to taking disbursements from your account. Your contributions are always free to be withdrawn without taxes or penalties. On the other hand, if you're not careful – when you're taking out the earnings on your principle – you could end up having to pay taxes and fees. Not to mention – by withdrawing your money you're killing the effects of compound interest.
If at all possible, try not to withdraw your money – and if you do, make sure you've got a qualified reason!
Now start saving!
Have you considered taking your money out of your Roth IRA early? Was it for a qualified or non-qualified reason? Are there other reasons you can think of that you might withdraw your money? Tell us what you think in the comments.
Today I want to do a quick post on the basics of the Roth IRA. I've done several posts on them previously, but all on a specific point about Roth IRAs, including the 2010 Roth IRA Conversion. Today I'll bring it all together in one comprehensive Roth IRA post.
What Is A Roth IRA
The Roth IRA account was brought into existence in 1997 when the Taxpayer Relief Act of 1997 was passed. The chief sponsor of the bill was the late Senator William Roth of Delaware. (Does the name of the account make more sense now?). The Roth IRA (Individual Retirement Arrangement) is a retirement vehicle in which you can invest in securities, stocks or mutual funds (although other investments, including derivatives, notes, certificates of deposit, and real estate are possible).
The reason that Roth IRAs have become so popular since they passed is the fact that they are a tax free withdrawal retirement account – since you don't have to pay taxes when you take the money out at retirement.
Contribution Limits For 2010
The Roth IRA contribution limits have been the same since 2008 at $5,000. If you are age 50 and above you can make an extra contribution of $1,000, which means you can contribute a total of $6,000. It isn't anticipated as of yet that they will be rising next year. Time will tell for sure. Here's a quick chart showing where the contribution limits have been since 2002.
Year
Age 49 and Below
Age 50 and Above
2002-2004
$3,000
$3,500
2005
$4,000
$4,500
2006-2007
$4,000
$5,000
2008
$5,000
$6,000
2009
$5,000
$6,000
2010
$5,000
$6,000
Roth IRA Income Limits
The income phaseout limits for contributing to a Roth IRA start getting phased out at about $105,000 for single filers, and at $167,000 for married filing joint filers on a Roth IRA.
IRA Type
Single
Married Filing Jointly
Roth IRA
$105,000 – $120,000
$167,000 – $177,000
Once you reach the lower end of the phaseout limits, figuring out how much you can contribute to the Roth IRA becomes a bit of a complicated math problem. Basically you will subtract your modified adjusted gross income from the upper end of the phaseout range, divide by the amount of the spread in the range. You'll get a percentage after you divide. That percentage is the amount of the full $5,000 that you can contribute. So if you're resulting number is 66% – you can contribute 66% of $5000 – or $3300.
For a full explanation of figuring out how much you can contribute, check out this post on Roth IRA Eligibility.
At What Age Can You Contribute To A Roth IRA?
As long as you have an earned income along with a W-2 or 1099, there are no age restrictions on who can contribute to a Roth IRA. That babysitting job your kid had last year probably won't cut it, but if they pushed carts at the local grocery store – they're good to go.
Opening A Roth IRA
Opening a Roth IRA is a pretty simple process that shouldn't take you more than an hour or two from start to finish. Basically you just have to figure out where to open the account (bank, discount brokerage or full service mutual fund company), how you'll be funding your investments, and what types of things you'll invest in.
Roth IRAs are one my favorite investment vehicles, and one that I invest in first. I love the idea of diversifying my tax situation at retirement by having a mix of taxed and non-taxed withdrawals to enjoy at retirement. That way I'll make sure that no matter if my taxes are higher or lower at retirement, it won't matter very much because I've got investments that were taxed previously, and ones that will be taxed now.
So what do you think of the Roth IRA? Do you have one, and would you suggest others get one too?
If you have a few extra dollars lying around in your budget after you pay all your bills and do some basic saving, you may be wondering what to do next. You may even hear your friends or colleagues talking about investing, but you might not know where to start. I'm here to help. Now I'm not going to give you specifics about which investments to choose. But I will provide some guidelines for investing as well as some examples of different ways of investing money.
Taxable vs Tax-Advantaged Investing
The first thing you might want to know about investing is that there are two major categories of investing: taxable and tax-advantaged.
Tax-advantaged investing uses some type of tax related retirement account (or retirement “savings vehicle”), which encourages you to you save for retirement by helping you avoid taxes.
If your goal for investing is a comfortable retirement, and thus, you don't need the funds till you retire, then you should strongly consider a tax-advantaged account. Common accounts to choose from are the 401k and the IRA.
Taxable investing is anything other than tax-advantaged investing. If you don't open up a special account to invest in, then you are just doing normal taxable investing. Taxable investing is very flexible since there is no special account to hold the funds in. You can move your money in and out as you please.
Most investors do a combination of both. Invest the maximums into their tax-advantaged accounts each year, and then start pouring money into taxable investing.
Diversified vs Speculative Investing
Another concept you should learn about before investing is the idea of diversification. This is the act of putting your investment dollars in multiple assets to achieve proper asset allocation. There's lots of debate as to what that looks like. But the idea is to spread your money around so that if one investment fails it won't wipe out your whole portfolio, yet you'll still achieve decent results.
Therefore, diversified investing, involves putting your money in several different asset classes, and seeking a modest return without great risk.
Speculative investing is a little harder to define. But like explicit or objectionable material, you know speculation “when you see it”. Speculation is putting your money into assets where their is a lack of knowledge about the investment, a high level of risk, or simply where you have too much of your portfolio in one asset class. Some could argue that all stock investing is speculative. But for simplicity sake, I'm defining it this way.
The bottom line is that if you want to seek a decent return over the long-haul and preserve your capital (i.e. hold on to your money), you should be involved in diversified investing, and not be a speculator.
Different Types of Investments
Armed with the knowledge of these investing subjects, you're ready to go out and start investing. But where should you put your money? Here are some of the most common investment types (or asset classes) for you to consider.
Stocks – Buy stocks of ownership in a company. Your investment grows as the company performs well.
Bonds – Buy a debt security from a company or organization. You get paid when they pay their debts.
Cash – Buy into currency, money market funds, and CDs. Your money is stable and most of the time insured from loss.
Funds – Buy groups of stocks or bonds called funds. Common funds are mutual funds and index funds.
Real Estate – Buy land. A real asset you can put your hands on.
Businesses – Buy equity in a business. You get paid as the business grows.
Personal – Buy an education, a new suit, or a car to get you back and forth to work.
Other Assets – Buy art and collectibles. Hang your investment on the wall.
Commodities – Buy gold, silver, or platinum.
Which combination of the above you choose will depend on your understanding of the types of assets and your personal risk tolerance.
How do you invest your money? What strategies do you use? Which asset classes do you invest in and why?
This guest post comes from PT. Learn more about investing and see reviews of the best online stock brokers at his blog, PTMoney.com.
You've finally been convinced that opening a Roth IRA is a good idea, and you've decided to take the plunge. Great! But what's next? How do you open an account, and where are some good places to hold your Roth IRA?
Today I'd like to cover the basics of opening a Roth IRA and look at a few good low cost brokerages where you can keep your account.
Take Care Of The Basics Before Your Roth IRA
Before we even jump into the basics of opening a Roth IRA, I suggest that you first get the rest of your financial house in order. That means doing the following things:
Save up an emergency fund: We've saved up 12 months of expenses to cover just about any eventuality that might come up. I'd suggest you save at the bare minimum $1000, but even better – 3-6 months of expenses.
Pay off all debt: I suggest you pay off all debt that you might have. If you don't any gains you might realize by investing will be offset by large debt interest payments. Get it paid off ASAP!
Once you've paid off all your debt and saved for a rainy day, you're probably read to start investing. At our house we follow the Dave Ramsey plan – but not to the letter. He suggests investing 15% of income. We're going to invest closer to 20-25%.
So what's an easy way to get started investing? When you've paid off all your debt, take the money you were paying on that debt, and instead start investing it.
My suggestion for investing is as follows. Invest in a company 401(k) or other employer sponsored plan up until the match (100% return!). After the match switch over to the Roth IRA (which we're talking about today!). After the Roth IRA switch back over to your 401(k) until it is maxed out. So again – this is the order:
401(k) til employer match is reached.
Roth IRA til maxed out.
401(k) (or other plan) til maxed.
How To Open A Roth IRA
Opening a Roth IRA shouldn't take very long, and in most cases can actually be done in a half hour to an hour.
When opening an account usually you'll need the following information – although it may vary a bit from institution to institution.
Social security number.
Bank account information.
Information about employment.
Money to open the account. (You may need $25 or you may need $3000 depending on where you open your account. )
An hour or so.
Before you even open an account, however, you'll need to figure out what financial institution, mutual fund firm or brokerage you want to open your account with.
Banks
Your local bank or credit union can often open up an account for your Roth IRA. While having an account with your local bank is usually convenient, it isn't often the best option. The reason? The banks usually have limited investment options for your account, usually limited to CDs, money market funds, and other cash accounts. The fees they charge are also often higher than the fees you would find with a discount brokerage or full service mutual fund firm.
Full Service Mutual Fund Firms
Full service mutual fund firms are typically one of the better places to start your account because they will have a nice variety of mutual fund options with low expense ratios and varied investment options. They are quite often the best place to purchase index funds, target date retirement funds, mutual funds and similar investments. Some of the better options that offer Traditional and Roth IRAs and many investment options include.
The downside to investing at one of these firms is that they often have minimum investments that you can make, which if you don't have a lot to start your account with can mean you're not able to invest with some of the companies. Some will also charge more for individual trades, and have account management fees. Some of these fees can be waived if you make a certain minimum investment and/or if you commit to investing a certain amount every month. Before you sign up, make sure you know what the minimums, fees and other account terms are.
The key to opening an account with a mutual fund firm is to do your research and to know what you're getting into. Never invest in something you don't understand.
Discount Brokerages & Robo Advisors
If you're a more hands on investor or you like to invest in single stocks an online discount broker might be a good option for your account (I like to buy index funds at a mutual fund firm and forget it myself!). Discount brokerages will allow you to access stock trades, options trades, Exchange Traded Funds (ETFs), mutual funds and other assorted investments. Individual stock trades will usually cost in the $2 – $10 range, which is probably going to be cheaper than making stock trades at a mutual fund firm listed above. Some of the options I recommend:
The next most important thing to decide is what to invest in once you open your Roth IRA. If you're just starting out like I am I'd probably suggest to find a good index fund and some low cost mutual funds. If you're newer to investing as I am or if you don't want to be actively managing individual stocks/etc, starting out with a good index fund will probably be a good option. Depending on which Roth IRA account custodian you choose, your options for investments may vary. Again, do your homework, and choose one that works best for your situation.
Do you have a Roth IRA? What type of account custodian did you choose (mutual fund firm, discount brokerage, bank or credit union)? What types of things are you investing in? Tell us your thoughts on opening a Roth IRA in the comments.
I‘ve been talking quite a bit since I launched this site about Roth IRAs, and why they're such a great idea. After all, who doesn't like tax free money at retirement? (Can you tell that I like them?)
One thing I haven't examined very closely, however, is the fact that Roth IRAs are not available to everyone. It's like when you were a youngster and you saw that they were giving out full sized candy bars at one house at Halloween. Everyone got one until they got to you – and the candy ran out! Sorry!
Roth IRAs are like those full sized candy bars – they aren't available to everyone, and you may be left out in the cold if you don't meet the requirements.
Age Restrictions?
Roth IRAs are available to anyone regardless of age, however, there is a catch. The child needs to have claimed “earned income”. That means that your child will actually need to have received a W-2 or 1099 showing the income made. So that babysitting job they had last week, or the job cutting the neighbor's lawn probably won't cut it. So, no age restrictions, but there is a need for “earned income”.
Modified Adjusted Gross Income Affects Roth Eligibility
Your MAGI or Modified Adjusted Gross Income will be one of the most important factors determining whether you are eligible to contribute to a Roth IRA. Your MAGI calculation will be used to determine if you exceed the Roth IRA phaseout limits to be able to contribute funds.
If you fall somewhere in the middle of the phaseout range, it can mean some fancy math trying to find out how much you can exactly contribute to a Roth. First, here's the phaseout limits:
IRA Type
Single
Married Filing Jointly
Roth IRA
$105,000 – $120,000
$167,000 – $177,000
Traditional IRA
$55,000 – $65,000
$89,000 – $109,000
Example: Let's say you make $110,000 and you're single. How much could you contribute to a Roth IRA since you're smack dab in the middle of the phaseout range? Here' s how you figure it out.
Find out the phase you fall into. In this case you fall into the $105,000-$120,000 range.
Subtract your MAGI from the upper range of the phaseout range. In this case that would mean $120,000-$110,000 = $10,000.
Divide the number in step two by the amount of the spread in the range ($10,000/$15,000 = .6667 or 66.67%)
You are able to contribute 66.67% of the $5,000 limit. Since you can contribute 66.67% of the limit that comes to a total contribution for the year of $3333.33.
Under The Phaseout Roth IRA Contribution Limit
For the 2010 tax year Roth IRA cntribution limits stay steady at $5,000. For those over the age of 50, you can make a catch up contribution of $1,000. That means for 2010 you have a total contribution limit of $6,000. If you’re married, that’s $6,000 for you and $6,000 for your spouse.
Start A Roth IRA Today – Time Is Your Friend!
If you're eligible for a Roth IRA and you've decided to open one, do it now! The longer you invest your money for, the greater the effects of compounding interest! So get moving!
