1. Money

A Roth IRA Is the Perfect Tax Shelter

You Aren't Likely to Find a Better Investment Account

By

Roth IRA Tax Shelter

A Roth IRA is the best tax shelter available to the middle class because you can avoid all taxes on capital gains, rents, interest income, and dividends if you follow the rules.

Nick M Do / Photographer's Choice RF / Getty Images

There is no account, anywhere in the world, that is as beneficial to the typical middle class investor as the Roth IRA is.  Using a Roth IRA you are probably going to build wealth faster, and be able to keep far more of your income, due to the tax benefits of the retirement plan.  

To be blunt, the Roth IRA is, in many ways, the perfect tax shelter.  That is the reason Congress is so strict about the amount of money you can contribute to it each year; if they didn't, everyone would shove as much of their cash as they could into one of these goldmines.  With a Roth, you pay no taxes on your dividend income.  You pay no taxes on your capital gain income.  You pay no taxes on your interest income.  You pay no taxes on your rents.  

Those advantages alone make it easy for a Roth IRA to crush a plain vanilla brokerage account, as well as trounce 401(k) plans (the biggest advantage of which is often the matching funds that come from your employer).  When your assets reach sufficient size, you can even begin managing your Roth IRA as a so called self-direct Roth IRA and use it to buy entire apartment buildings or, in some cases, minority stakes in private businesses.  It can grow right along with you, whether you want to own stodgy corporate bonds or develop a hotel; whether you have $1,000 or $100,000,000.

You can even tap into a Roth IRA without penalty to buy your first home or, in some cases, fund a medical emergency.  If you absolutely must, you can even withdrawal past principal contributions you've made to your Roth IRA without suffering the massive taxes and penalties that are levied on Traditional IRAs and 401(k) plans.

A Scenario That Illustrates How Powerful a Roth IRA Tax Shelter Can Be

Imagine you are 18 years old.  You plan on working until you are 65 and then retiring.  You meet the love of your life right out of high school and get married.  The two of you decide that you don't want to be rich, but you do want to be secure.  You stick to one, single rule throughout your entire career: No matter what happens, come hell or highwater, prosperity or poverty, you will fully fund your Roth IRA up to the contribution limits each and every year.  No matter how desperately you need that money, you will never touch it; instead, you will protect it and allow it to compound tax-free.

In the first year, 2013, the most you can each put away into your Roth IRA is $5,500.  Between the two of you, that is $11,000, or $916+ per month.  You buy used cars instead of new, clip coupons, and eventually earn more as you work your way up the career ladder.

What could you expect?  Based on the returns generated by stocks for the past century, through bull markets and bear markets, assuming you reinvested your dividends, you could easily have $9,591,723 when you went to retire.  Taking the same inflation rate we've experienced over the past century, as well, that works out to roughly $1,500,000 in today's purchasing power.  (Remember: It is purchasing power that counts.)

It would be easy to convert that $1,500,000 into a stream of passive income ranging from $50,000 to $75,000 tax-free in today's dollars.  Read that again: Tax free.  You'd never touch the principal.  You could live well for the rest of your life - statistically, another two decades at least, and probably longer if medical science continues to improve over the next half century - and never touch a penny of principal.  Instead, when you died, the money in your Roth IRA could be put into trust funds for your children and grandchildren, or given to charity.

All of this would be achieved without you ever being in the corner office; without ever having stock options or corporate jets; without ever winning the lottery or inheriting a windfall from a long lost uncle.  

How to Setup a Roth IRA

Since a Roth IRA is a type of an account - much like a savings account or brokerage account - it can be opened at nearly any mutual fund company, stock broker, or, in some cases, even a bank (although your options would be limited to certificates of deposit, which probably isn't a good long-term strategy since you have very little chance of beating inflation).  The big thing to watch out for is the fees.  You should not be giving up a considerable percentage of your assets, or paying high commissions.  The younger you are, the bigger those fees eat into your family's future wealth.

©2014 About.com. All rights reserved.