In our last newsletter, I shared some tips on picking the right investment for your goals. But for many of us, another big question is this: “Where do I actually hold my investments?”
Much like artists generally have themes that run through their work, a prevailing theme you’ll find in financial planning is, “take advantage of tax shelters whenever possible.”
What’s a Tax Shelter?
Right now, the concept of a tax shelter might be as foreign to you as someone speaking an unfamiliar language. Honestly, for years I didn’t know the difference between a 401k and an IRA… However, once you’re able to work through this mumbo-jumbo of alphabet tax shelter soup, you’ll find that it isn’t as hard as it seems.
For most of us, the place to start is a Roth IRA.
Who Should Use a Roth IRA?
A Roth IRA is a wise choice if you want to save money for retirement, anticipate that you may earn more money in the future than now, and need flexibility with your money.
For most creatives, the word “flexibility” makes a Roth IRA attractive.
Because a Roth IRA gives you no tax break immediately, money you add to the account can be withdrawn without penalty. Interest can be withdrawn after five years or at 59 ½ without penalty (whichever is later), OR for a “qualifying event.”
What Is a “Qualifying Event”?
Here’s another great reason to use a Roth IRA: there are many scenarios that allow you to take out your money.
If you have education expenses, are buying a home or become disabled, your money is available. You’ll have to follow IRS guidelines, but generally if you need the cash, it’s available. You’ll probably have to pay tax on any gains, but you won’t be subject to penalties as long as you follow the rules.
What If I Need Money for Another Reason?
Another reason I love the Roth IRA is that there are some handcuffs. As humans, we always have plenty of needs for cash that are RIGHT NOW! That’s where penalties work in our favor; by making it so that we can’t just take money out for any reason, we leave the money for retirement, when we’ll need plenty of it.
If you need money for reasons other than a qualified expense, you’ll pay a 10% penalty on any gains that you’ve made on your investment.
How Should I Invest a Roth IRA?
Just like I don’t want anyone to tell me what to do creatively, the government doesn’t give you many restrictions on your investment options. You can save into a basic savings account, a CD, an exchange traded fund, mutual fund…nearly whatever you wish.
Picking the right investment for you is a different story. As I mentioned two weeks ago, focus on when you’ll need the money to pick an investment that’ll best help you toward your goal.
Are There Investments That Shouldn’t Be In a Roth IRA?
Generally speaking an annuity may be a bad option for a Roth IRA. Because an annuity is a tax sheltered investment, you lose the tax benefits of the annuity when you place it in a Roth IRA (because the Roth already is a tax shelter!). People pay some fairly high fees in annuities for that tax preferential treatment, so you’ll avoid fees in many cases by looking elsewhere.
How Do I Open a Roth IRA?
Once you decide what investment you want to use, contact that company and ask them how to open a Roth IRA with them. Alternatively, if you’re using a mutual fund or exchange traded fund, you could open a brokerage account with a popular firm like TDAmeritrade, Scottrade or Charles Schwab. Firms like these offer low-cost services and have online support people available.
Are There Tax Forms With a Roth IRA?
Yes. You’ll have to tell the government you made a contribution by adding the contribution to your tax return. Also, you’ll receive a record each year from your Roth IRA custodian (the investment company holding your Roth account) showing the IRS how much you currently have invested in your Roth (you don’t need to file this form).
What Are Roth IRA Contribution Limits?
The basic limit in 2014 is $5,500, but changes each year AND there are plenty of exceptions. First, if you’re over age 50 you can make an additional “catch up” contribution of another $1,000 (once again, this is a 2014 rule…if you’re reading this in the future, search for current rules). Also, if you earn over 114k per year if you’re single or $181k if you’re married (in 2014), your income is subject to “phase out” limits, lowering the amount you can invest. Once you reach $129k (single) or $191k (married) you’re no longer allowed to contribute.
Don’t Make The Mistake of Forgetting Taxes!
Choosing an appropriate investment is important, but by placing the right investment into the perfect tax shelter (such as a Roth IRA) you’ll compound your returns by reducing the friction caused by bigger and bigger tax bills.