Young couples often must decide whether to pay for current expenses or put money away for retirement. You might be able to address both concerns through an investment program that generates current income and long-term growth while giving you the flexibility to get at your invested money should the need arise. You most certainly can contribute to mutual funds and a Roth IRA. Separately or together, they can be a part of your overall investment program.
A mutual fund is a big pool of money -- contributed by numerous investors -- that buys a portfolio of stocks, bonds or other types of assets. When you buy shares in a mutual fund, the fund company accepts your money, creates new shares for you, and invests your money in additional assets. You can buy or sell shares at will, so your money is always available within a few days, even if you have to sell your shares at a loss. Mutual funds add to your income with dividends, interest and capital gains. Your net income from a mutual fund is taxable unless the portfolio is made up of tax-free instruments like municipal bonds.
A Roth Individual Retirement Account is funded with money on which you’ve already paid taxes. Your investments grow tax-free. Once you have held the Roth IRA for five years and you are at least 59 1/2 years old, you can withdraw your earnings tax-free. You can withdraw your contributions at any time without taxes or penalties. You can hold individual stocks, bonds and other financial instruments in your Roth IRA. You can also hold mutual funds.
If your annual income exceeds IRS limits, which change from year to year, you will not be able to make Roth IRA contributions in that year. The IRS publishes the latest income limits and notes exceptions to age-related rules in Publication 590.
Taxes from Mutual Funds
Mutual funds pay dividends. The tax on these dividends depends on their source. Dividends from interest create ordinary income taxed at your marginal rate -- the tax rate on the “last dollar” you earn during the year. Dividends from stock dividends and capital gains may qualify for a tax-break. To qualify, the dividends must come from stocks that are easily available in the United States. The capital gains must be long-term, arising from the sale of securities held by the mutual fund for longer than a year.
You create your own capital gains or losses when you sell your mutual fund shares. If you hold the shares for a year or less before selling them, the IRS will tax the the profits as short-term gains at your marginal rate.
You can avoid all those taxes by holding your mutual funds in your Roth IRA. Not only do you save on taxes, you also avoid draining off part of your investments to pay taxes. All your money stays on the job. You can build up a nest egg without creating a penny of additional tax.
However, holding your mutual funds in a Roth creates income you won’t be able to spend for years or decades unless you’re willing to pay taxes and penalties on early withdrawals. In time, your income might dwarf your contributions, so having the ability to freely withdraw just your contributions until age 59 1/2 might seem like cold comfort.
A financial adviser might be able to help you to choose among your many alternatives. You might split your investments between mutual funds and other vehicles, both inside and outside of Roth IRAs. You might also consider splitting your retirement investments between Roth and traditional IRAs.
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