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My nephew who is 24 years old often asks me for financial advice but I'm not sure how to answer him on this one, so hopefully someone here can help.
He currently makes about 50K a year (gross). Single, lives in an apartment so just takes the standard tax deduction rather than itemized.
Having graduated from college two years ago, he currently has almost $9000 in an IRA CD, earning just under 3% until it matures in February. He also has a 401K at work, where his employer matches part of his pretax contribution; he currently has about $3500 in that.
One of his friends asked him why he hasn't also opened up a Roth IRA in additional to the traditional IRA CD that he already has. He asked me what the advantages would be to that, if any, as compared to just continuing to contribute to his traditional IRA CD every year when it matures. I wasn't sure what to tell him about that, never having had a Roth IRA myself.
My first inclination was to suggest that for this year (2008) since he can contribute up to $5000 to a personal retirement account, perhaps he should add $2000 to the existing IRA CD in order to bring it up to $10,000 which will qualify him for a slightly higher interest rate; and then put the remaining $3000 into a new Roth IRA CD. We both realize that due to the existing 401K at his employer's, the deductibility of his personal IRA contributions will be very limited. But other than that, I have no idea whether a Roth IRA is "better", "worse", or "just about the same as" having a traditional IRA for a 24-year-old; should he simply just stick with having a personal IRA CD plus the 401K that his employer affords him?
The big advantage a Roth has over a traditional IRA is that all GAINS are TAX-FREE. When he finally begins taking withdrawals in retirement, all withdrawals from a Roth will come out tax-free, while withdrawals from the traditional IRA (and the 401k, for that matter) will be fully taxed at his regular income tax rate. The Roth has other advantages as well, such as the ability to withdraw your contributions at any time with no tax or penalty, no mandatory withdrawals at age 70 1/2, etc.
I like your idea of putting $2k into the traditional to get the higher interest rate, and the rest into a Roth. If I was just 24, however, I wouldn't be putting too much money into CDs. I'd go with stocks, funds or ETFs inside my Roth. Yes, even now.
The big advantage a Roth has over a traditional IRA is that all GAINS are TAX-FREE. .... If I was just 24, however, I wouldn't be putting too much money into CDs. I'd go with stocks, funds or ETFs inside my Roth. Yes, even now.
Thanks for the input. So in other words the interest earned under a Roth IRA is NEVER taxed? neither when actually earned, or when withdrawn as part of retirement-years distributions?
Being a long-term/long-view investor myself, I understand your comment about going for investment products in a Roth; but also being extremely risk-averse (as is my nephew) I would hesitate. His view is that he's more comfortable with only having his 401K (which is not funded ENTIRELY with 'his own money', since his employer is contributing as well) in any kind of a risk-based retirement vehicle. If I were in his position (at any age) I would definitely feel the same way: I'd rather gamble with money that came from someone else's pocket than from my own.
Thanks for the input. So in other words the interest earned under a Roth IRA is NEVER taxed? neither when actually earned, or when withdrawn as part of retirement-years distributions?
Correct.
But Roths are not tax deductible when opened. Regular IRAs are. It is still the wiser choice to get a Roth. I would actually put everything into the roth because it is that much better. The few dollar difference now is nothing compared to the many thousands he will have TAX FREE at retirment with the Roth.
He needs to get a balance of small, large stocks and bonds, metals, commodities, international etc... and know what percentage is going into each and stick with that plan. He can have the riskier ones in the 401k or IRA or wherever, but as long as they equal to the predetermined percentage allocation, he will do fine. You can not and will not keep up with inflation with CDs.
Get him to read a book or visit a good financial website about asset allocation and he will sleep better at night knowing he has a little bit in everything that will go up and down at different points, but ultimately make him more money over his carreer than the current CDs he has.
good luck
Wow, 24 huh? That's great. I wish him well. Get a plan and stick to it.
He needs to get a balance of small, large stocks and bonds, metals, commodities, international etc..
I probably should have mentioned that he does already own some stocks; now about 150K worth (or was before the recent meltdown!). He inherited them from his paternal grandfather who died about 10 years ago. At that time they were a weird mix of things, some companies such as Ford and others that were what I call 'penny stocks'; he asked me what he should do and I suggested he sell most of them and buy more solid companies, some USA based and some international. So his portfolio now includes two large oil companies, a gold mining company, a large international ad company, a Canadian railroad, a non-US car manufacturer (he dumped Ford, and a good thing too), a IT company, a hotel/car rental chain, Disney stock that I bought for him as first birthday gift, and shares in an alternative-energy company that I gave him for his 21st birthday and told him to hold onto for at least 20 years. But none of those are in retirement accounts; they're for longterm investing, or at least I hope he'll stick to that mindset.
The kicker of course is that whenever he does sell them he'll be slammed with capital gains tax bigtime, unless the tax laws change considerably.
The kicker of course is that whenever he does sell them he'll be slammed with capital gains tax bigtime, unless the tax laws change considerably.
The trick is to use the investment vehicles to your advantage. Growth stocks should be in the taxable account. Dividend paying stocks should be in the tax free/deferred account. The object is to keep a growth stock for many years as it multiplies many times over, then sell it at a low "long term capitol gain". Small price to pay. The dividend paying stocks/funds etc... in the deferred accounts will not matter. Even CD's in the deferred accounts are 'tax free'.
That type of allocation helps. good luck.
Yeah, he's doing much better than a lot of people. Good for him! good luck.
Some of the stocks do pay dividends, and on my original advice he has been directing that those be reinvested via the company's DRIP (if offered). And two of the stocks that I suggested he buy when the original ones were sold, have split at least once since he acquired them (one is an oil stock that split twice ). So between the increase in value and the increase in shares via the dividend reinvestments and the splits, he can't complain; even if he were to sell them now (which he doesn't plan to do) he would see a profit ... just less of a profit now than, say, six weeks ago.
So it sounds as if the only downside to a Roth is that yearly contributions aren't tax deductible, as is the the case with a traditional IRA CD. I suppose if he were to ever switch jobs to a company that doesn't offer any kind of 401K plan (which limits the deductibility of his personal IRA contribution), then the deductible traditional IRA would make sense to have, or at least to contribute to... if only to get the tax deduction. But as long as he's got an active 401K it sounds as if his best bet will be to bring his existing IRA CD just up to the $10,000 level (in order to get a better rate) and then put the rest and all future contributions as long as he's with a pension-matching company into a personal Roth instead.
So it sounds as if the only downside to a Roth is that yearly contributions aren't tax deductible, as is the the case with a traditional IRA CD. I suppose if he were to ever switch jobs to a company that doesn't offer any kind of 401K plan (which limits the deductibility of his personal IRA contribution), then the deductible traditional IRA would make sense to have, or at least to contribute to... if only to get the tax deduction. But as long as he's got an active 401K it sounds as if his best bet will be to bring his existing IRA CD just up to the $10,000 level (in order to get a better rate) and then put the rest and all future contributions as long as he's with a pension-matching company into a personal Roth instead.
I think you are mistaken about the deductablity of his IRA contributions. The amount is $52k and in 2008 it is $53k or less that one would have to make to be able to deduct the IRA contributions.
Having said that, I still think, or actually it is proven mathematically that the better option is to go with the Roth and get the money tax free at retirement.
In 40 years or so, when he has $750,000 in one of the accounts and can withdraw it tax FREE, he would not miss the couple of hundred $$ or so amount that was tax deductable each year. There are graphs and charts and figures that back up this theory. I'm sure you can find it with a Roth vs Traditional Google search. ESPECIALLY for a 20 something. There's also a chart for that. Finding out at what age it is still worthwhile to go with the Roth.
IMO, the only time that a traditional IRA would be preferable over roth is if one is middle aged or older and invests in very conservative securities. The idea is that you are taxed upon withdrawal when you are retired and in a lower tax bracket. For someone young who's more aggressive in their investments, roth is preferable by far. I'd say he should max out his employer-match 401(k) contributions, then max out roth contributions.
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). So between the increase in value and the increase in shares via the dividend reinvestments and the splits, he can't complain; even if he were to sell them now (which he doesn't plan to do) he would see a profit ... just less of a profit now than, say, six weeks ago. 
