Saving for Retirement without a 401(k)

I'm 26 and don't have a 401(k) plan at work. How do you suggest I start saving for retirement?

Question:

For a young person who is looking for the right type of retirement account, there's a pretty easy answer: the Roth IRA.

Here's why: A Roth IRA allows you to deposit up to $2,000 a year into an account and leave it there until you reach retirement age (59 1/2). At that point you are allowed to withdraw it. Unlike a traditional IRA, you pay tax on that $2,000 up front, before you deposit. But from that point on, any interest or other income your deposit earns is yours to keep, tax-free, after you reach retirement age.

The money in your Roth will have many years to grow. The power of compounding will allow interest you earn one year to earn more interest the next year, and so on, until you've accumulated quite a nest egg by retirement. And with a Roth, you'll be able to withdraw the money at retirement tax-free.

A regular IRA, by contrast, allows you to make your $2,000 annual deposit with pre-tax dollars, so you save money on your taxes each year. But when you withdraw the money at retirement, you'll have to pay tax on both your original deposit and on any interest or capital gains the money has earned over the years.


So let's compare investing the same $20,000 in a Roth and a regular IRA. Assuming you are in the 28 percent tax bracket, you'll have paid about $5,600 in taxes on the $20,000 before you ever deposited it. But if that $20,000 grows to be worth $200,000 by the time you retire, you'll be able to take out your $180,000 profit, tax-free. In a regular IRA you would have to pay more than $54,000 in taxes on that same gain. So the upfront taxes that you pay on a Roth spare you almost 10 times the taxes you would otherwise owe when you retire.

Investing within Your Roth
Once you've opened your Roth IRA account, you'll need to decide how to invest the money in it. (Bear in mind that an IRA isn't like a bank account where your money earns interest if you leave it there. Think of your Roth IRA as a big purse for your money where it sits until you decide how to invest.) You can opt to invest your IRA money in mutual funds, stocks, bonds or other securities, depending on the arrangement you set up with the brokerage or bank that maintains your IRA for you.

If you opt for a "self-directed" IRA, you will have the choice of many securities, things such as certificates of deposit, which earn interest, or stocks, which you can choose yourself. Once your money is invested within your IRA, you'll have the choice of buying and selling stocks, shares of mutual funds or other securities.

Are there penalties for early withdrawal?
Unlike regular IRAs, which penalize you for withdrawing your money before retirement, a Roth IRA allows you to make early withdrawals. You are only allowed to withdraw your original contributions without tax or penalty, but not any capital gains or interest. So, for example, if you've made $2,000 contributions for six years and the total value of your Roth is $47,000, you can withdraw only $12,000. But if you can, resist the temptation to withdraw anything. The longer the money stays in your account, the more powerful the compounding effect and the larger the nest egg you'll have when you retire.

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