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I'm 19 and just starting to invest in mutual funds. I'm trying to decide whether opening a traditional IRA or Roth IRA is a good idea for me right now. What advantages would a traditional or Roth IRA have over a normal mutual fund account? The money I'm investing isn't for short-term use, although I might need it for a down payment on a house five years from now.
-- Doug, Kennesaw, Georgia
Ah, it's so nice to see someone so young, so optimistic, so willing to save. Why when I was 19, I was...never mind, I don't want to plant any dangerous ideas in young impressionable minds.
First off, let me explain the advantages of investing in an IRA versus a regular taxable mutual fund account. If you choose a traditional IRA, you get an immediate tax deduction equal to the amount of your investment.
So if you make the maximum allowable contribution of $3,000 for this year -- an amount that rises to $4,000 in 2005 and $5,000 in 2008 -- and you're in the 15 percent tax bracket, you would reap immediate tax savings of $450, plus the earnings in your IRA account would grow tax-free until you withdraw them, preferably in retirement. Ideally, the money you save in taxes could also find its way into some form of savings.
A Roth works slightly differently. The maximum allowable contribution for a Roth is the same as for a traditional IRA, except that you get no immediate tax deduction with the Roth. But in return for investing after-tax dollars -- that is, money on which you've already paid income tax -- you get to withdraw your contributions and all the account's earnings free of taxes later on.
Of course, there are a slew of rules that determine who is eligible for traditional deductible IRAs and Roth IRAs, not to mention still further regulations concerning the tax treatment of withdrawals.
To see which type of account you're eligible for and what size contribution you can make, click here and then click on "What Kind of IRA is Best For Me?"
For details on the taxability of withdrawals, check out Publication 590: Individual Retirement Arrangements, which you can find at the Forms and Publications section of the IRS Web site.
Which is better?
So which is better for you -- a deductible IRA or a Roth? Generally, you're better off with a Roth if you expect to be in the same or higher tax bracket when you withdraw your money at retirement than when you put it in. The reason is that you will be paying taxes on your money at a lower rate today and avoiding taxes at a higher rate later on.
If, on the other hand, you expect to be in a lower tax bracket in retirement than today, then you would be better off avoiding the tax at today's higher rate and paying taxes at the lower rate later on.
Given your tender age, I would think that your income will increase during your lifetime and push you into a higher tax rate, which would likely make the Roth the better choice. (Of course, you never know what Congress will do when it comes to taxes.)
But the Roth has a variety of other advantages that I think make it generally a better deal, among them the fact that you can pretty much leave your money in a Roth as long as you please. After reaching age 70 1/2, you must begin making mandatory withdrawals from a traditional IRA.
The fact that you mentioned you may need access to your money within the next five years would also argue for a Roth over a traditional IRA. If you make a withdrawal before age 59 1/2 from a traditional IRA, you will typically not only owe tax on the amount withdrawn, but a 10 percent penalty.
That penalty is waived if the withdrawal is used to buy, build or rebuild a first home, although the withdrawal amount is limited to $10,000 and you would still owe the taxes. (For specifics on exactly what kinds of first-home expenditures qualify for this waiver, see the IRS publication I mentioned earlier.)
The Roth offers more flexibility. For one thing, you can always withdraw your original annual contributions without paying tax or penalties. So if you contributed $3,000 a year over the next five years, you would be able to pull out $15,000 without adverse tax consequences.
The rules are more complicated for getting at money rolled over from a traditional IRA to a Roth. Anyone facing that situation should click here for guidance.
What's more, Roth IRAs also waive taxes, and in some cases, penalties, on certain "qualified" distributions. Amounts up to $10,000 used to buy, build or rebuild a first home are considered a qualified distribution, and they're exempt from the 10 percent penalty as well. Thus, withdrawals of up to $10,000 for qualified first home expenditures can be withdrawn tax and penalty free.
So the Roth gives you access to higher amounts without taxes or penalties than a traditional IRA. If you don't feel that you could come up with enough for your down payment even with these relatively loose rules, however, then you'd want to be sure to do some savings in a taxable account as well.
One final note: If you really believe you'll be tapping into your Roth within five years, then you'll want to invest a lot differently than if you don't intend to touch the money until retirement.
Basically, a five-year time horizon means you should hold far less in the way of stocks or stock funds and much more in bonds than a longer time horizon wold require. For specific guidelines, check out our Asset Allocator.
And as you get closer to the time when you'll need your money, you'll want to shift the amount you'll need into cash (that is, a money-market fund or certificates of deposit) so you'll be sure the amount you need is available, even if the market happens to be in a funk.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Monday afternoons