Business - Personal Finance

Sunday, Nov. 08, 2009

Clearing up misconceptions about Roth IRAs

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 With a Roth, you pay taxes on the money you contribute, but not when it is withdrawn or on the amount it has earned.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.