Thursday, February 14, 2008

What Am I Going to do About a Roth IRA?

One of my goals for the year is to fully fund a Roth IRA. I have never had a Roth so I need to do a little research to figure out the why what where when and how of it.

Why a Roth?
If you've been reading for a while, you know that I liquidated some old stocks just before the market tanked with the intention of paying off some debts and funding a Roth. But why a Roth IRA instead of a traditional IRA? I first heard about the Roth on the radio back in 1998 when I was working in the back room at Borders. I was obviously making very little money at the time and had nothing left over to consider retirement planning, but even then I recognized that this was a good deal.

What's so great about a Roth? You pay taxes on that money now, put it into your account, then all the growth on it is tax free. And as a bonus, you can take the money that you already paid taxes on out of your account at any time (after 5 years) without any penalties. (Read about some restrictions here).

This can be huge. If you have a long time before retirement, then your growth potential is fairly high. This means that under a traditional IRA you would have amassed a substantial chunk of money that you will eventually be paying taxes on. With a Roth, you've paid the taxes on the smaller amount, and hopefully at a time when your tax bracket is lower (I for one am hoping to increase my income and consequently my tax bracket as time goes on. This may not be the case for those of you who are already making a lot of money). That's the simplified explanation that makes sense to me. If you want to get into more detail and compare the pre-tax value of this money, play around with this calculator at moneychimp. Also read Roth Accounts Are Bigger at Fairmark.

What Should I Invest In?
Ah, the million dollar question. There are as many choices as there are grains of sand in all the beaches of... well, not exactly but you get the picture. The key here is to figure out what my parameters are.
  • I don't have the time or interest to heavily research stocks and individual investments.
  • I want to keep my finances simple.
  • I want a decent rate of return that will beat inflation.
  • I want risk to be accounted for as I get closer to retirement.
There are two categories of investments that fit these parameters. Index funds and Target date funds.

Index Funds are mutual funds that invest in companies listed on any of the major market indexes such as the S&P 500. The advantage of this type of fund is that your returns will essentially match the market without you having to do any work. The disadvantage is that you might miss out on the high gains that could be possible from a more actively managed portfolio and that the market could be falling in the years you want to withdraw money. But then again, they say you can't time the market right? Index funds are easy and typically have very low fees associated with them. However, I am anxiously awaiting a post by Jacob at Early Retirement Extreme about why one should not invest in an index fund.

Target date funds are a new breed that have become popular in the last few years. Once you select your target retirement date, the fund automatically adjusts its allocation of stocks, bonds, and cash as the years pass. In the early years the fund will be more heavily invested in stocks for aggressive growth, and will shift towards safer bonds and cash as you get closer to and into retirement. The main advantage of a target fund over an index fund is the fact that your portfolio is safer when you are close to retirement. You won't be as affected by a sudden market drop like we saw last month if your holdings are mostly bonds and cash. Read why target funds may not be for everyone at Kiplingers and their more recent article advocating target funds.

At this stage I am leaning towards a target date fund for my Roth rather than an index fund.

Where should I Invest?
I'm not going to work too hard on this one either. I want
  • low fees
  • an easy online interface
  • a solid reputation
Vanguard fits that bill for me. I used to have an index fund with them and I am familiar with their website and their service.

When and How Will I Invest?
This sounds like a simple enough question. The answer however may not be quite so simple. I have two options:
  • Invest in a lump sum. This is not possible for everyone, but I do have the money sitting in my ING account and I can invest the maximum within a week or so. That will get it out of the way and I won't have to think about it for the rest of year. I won't be tempted to spend it on other things that may seem more important in the moment such as traveling abroad this summer.
  • Invest a certain amount each month. If I have the money, why wouldn't I invest in a lump sum? That's the other million dollar question. I wouldn't have considered this as a real option if the market hadn't suddenly decided to wobble in January. With all this talk of a possible recession and an uncertain market, it is likely that stock prices could continue to fall over the next few months. I could take advantage of a strategy called dollar cost averaging. If stocks prices do continue to fall, then this would be a good way to get in on the sale prices. Of course, I can't predict exactly what the market is going to do, but with the way things stand, this might be the year when dollar cost averaging comes out ahead.
What's going to work for me? I think I will probably go with the psychologically simpler method and just do a lump sum investment.

Here's what I have decided: I will put a $5,000 lump sum into the Vanguard® Target Retirement 2035 Fund.

Okay wait! Being able to summarize all that thought and research into one sentence just seems wrong!


Jacob said...

"I don't have the time or interest to heavily research stocks and individual investments."

In that case, I think an index fund is a-okay, but you might want to reconsider once you pass $100k (unless you have such a high income that $100k is not significant). Target date allocation is fairly easy though, so you could save the fees by doing it yourself though.

Anonymous said...

I agree with just a little bit more research you could purchase the index funds seperately maintaining your desired asset allocation. This will most likely have a lower expense ratio overall at Vanguard than a target date fund. Heck, you could always look at the Target date funds asset allocation and adjust yours accordingly.

I've been using Vanguard for my ROTH for 2 years now and am very satisfied with their service. If you sign up for electronic statements/alerts the $20 yearly account maintenance is waived.