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Choose Roth if possible, then go to index funds

The Baltimore Sun

I am a graduate student, and don't have access to a 401(k) plan. Compared to people with 401(k)s, I am at a serious disadvantage as I try to save for retirement. The university pays me $24,000, and I contribute $4,000 a year to a Roth IRA. But I could save more if I had other options available. Is there anything I can do?

M.B., Minneapolis

As your question implies, the beauty of saving money in either a Roth individual retirement account, traditional IRA or 401(k) is that you insulate your money from taxes.

Avoiding taxes gives you a tremendous advantage because your savings can grow without being siphoned off every year at tax time. Without having to pay taxes, your $4,000 in a Roth IRA could become about $69,700 in 30 years if you average a 10 percent return annually on your money. But if you are investing in a mutual fund in an account that is taxed, you could end up with about $11,000 less - or $58,700, according to an estimate by St. Paul financial planner Marc Hadley.

This happens because of the power of compounding, or earning interest on interest. Whenever Uncle Sam removes taxes from your savings, less money is left behind in your account, so the power to earn money on it diminishes.

So you are wise to save as much as possible in an account that insulates earnings from taxes. And you are correct that you are exhausting options and will need to save more than $4,000 a year to have enough when you retire.

You can put $4,000 into a Roth IRA this year. In January, you can do it again for the 2007 tax year. Because you are using Roth IRAs, you will be keeping Uncle Sam away from that money for life. If you leave the money invested until you are 59 1/2 , you will never have to pay taxes on it.

But once you've exhausted your annual savings limit in a Roth IRA, you should open a taxable account at a mutual fund firm or a brokerage firm. It will be subject to taxes, but you can reduce the impact substantially. A smart approach would be to invest in index funds - one that invests in the Standard & Poor's 500 index or one that invests in the total stock market.

With an S&P; index fund, you would invest in 500 of the largest U.S. companies, including Exxon Mobil Corp. and Microsoft Corp. If you invested in the total stock market, you would have a broad investment in about 5,000 companies - the largest companies such as Exxon Mobil and smaller ones such as Coach Inc. You could invest in either index fund and hold it for life because each is well-diversified.

These index funds tend to result in fewer taxes than most other mutual funds because of how they are managed. If you invest in a typical mutual fund, which employs a fund manager to pick stocks, the manager is trying to hold onto the best stocks possible for you, so the manager sells stocks that aren't expected to keep rising in value. When he or she does that, there is a tax to be paid because Uncle Sam basically charges investors for making money on stocks, bonds and mutual funds. And ultimately, you are the one responsible for paying the tab.

The mutual fund company figures out what portion of the tax you should pay based on how many shares you own.

But with index funds, your tax responsibilities tend to be smaller than funds with a stock-picker at the helm.

Contact Gail MarksJarvis at or leave a message at 312-222- 4264.

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