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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?
—Allison
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contribute, but not when it is withdrawn or on the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.
Or you
could put the full
$1,000
into a balanced mutual fund that invests roughly 60
percent of your savings in stocks and 40 percent in
bonds. Last year, such a fund would have lost about 20
percent instead of 38 percent in the stock market, and
this year you would have regained much of that.
Individual
stocks would be the riskiest choice because it's more
difficult to pick winners than if you invest in many
stocks through a mutual fund.
That
said, it's sometimes difficult for beginners to find
places to start investing with
$1,000
or less. One place that does is the
T. Rowe Price
mutual fund company. The firm will allow you to open a
Roth IRA as long as you invest
$50
each month into mutual funds. Consider a target date
fund with the year 2050 in it. That is designed to pick
a mixture of stocks and bonds for people in their 20s.
This
would not be appropriate, however, if you are saving to
go to college or buy a house within five years. When you
have just a few years to save, the chance of losses
makes stocks less attractive.
If that
is your intent, keeping your money in CDs in a bank
might be the best approach. If you aren't sure about
your goals, you could use a Roth and invest safely in
CDs. Under the rules for Roth IRAs, you can remove
anything you deposit at any time as long as you leave
the interest you have earned in the account until age 59
1/2. If you need money earlier for college or a home,
the government lets you do it without penalty.
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