When it comes to investing for retirement in the U.S, there are several plans that can be used to achieve this. The commonest are the employer-based defined contribution plans like the 401(k), 403(b), 457 or the TSP. For more details on these, check out this article here
However, the Roth IRA which is not employer-based, can often be started by almost anyone in the US (you must be a legal resident and have earned income). I sincerely believe that this is the best retirement plan in this country and everybody should have one. Yes, everybody, including you reading this right now. If you have not opened one, it’s time to take action now. Sure, there are income limits to contributing directly to a Roth IRA, but if you are constrained by that, you can still contribute to it legally through the Backdoor Roth IRA strategy.
Currently, the annual contribution limit to the Roth IRA is pegged at $5,500. By next year, it is goes up to $6,000. And if you’re over age 50? You get an extra $1,000 of contribution (called catch-up contribution). So, let’s say, you turn 30 in 2019 and you start contributing $6,000 annually until you are age 65, you will have $1.12 million tax free at 8% compounded rate of return (for comparison, the S&P 500 since its inception in 1928 has had an average annual return of 10%) Of this $1.1 million, your contribution was only $210,000, the rest (>$900,000) were all growth. And you tell me compound interest is not a beautiful thing? Imagine, if you and your spouse did the same thing, you will have $2.2 million after 35 years. ALL TAX FREE! Mind you, this is regardless of your other investments like 401(k), 403(b), 457 or taxable investments.
This is why I believe that every American or legal resident who has earned income should invest in the Roth IRA before they max out their other retirement plans. Here are my other 10 reasons why:
#1 No Employer Needed
The 401(k), 403(b), TSP or 457 plans are employer based retirement plans. However a sizeable number of the population in this country work for an employer that does not offer a retirement plan. Yes, if you’re self-employed, you can open a solo-401(k) plan or a SEP-IRA but the majority of tax payers in the country are employees. So what to do if your employer does not offer a 401(k)? The Roth IRA is here to the rescue. You can open one online in under 10 minutes from any reputable investment company like Fidelity, Vanguard, T Rowe Price or Charles Schwab. Of course the employee without a retirement plan at work can also open a taxable investment account but ideally, this should be done after he has maxed out his Roth IRA account.
#2 Tax-Free Growth And Tax-Free Withdrawals
Tax-deferred growth + tax-free withdrawals (Roth IRA) is >> tax-deferred growth + taxable withdrawals (401k, 403b,TSP, Traditional IRA). This is self explanatory. Anything you can do to keep Uncle Sam from taxing you is a win for you. You pay your taxes and then put in money into a Roth IRA and never have to pay taxes again. Like EVER! Just like in the example above, over 2-3 decades of compounding, most of what will be in your Roth IRA account is mostly growth, not the money you actually put in.
#3 Best Retirement Plan For Estate Planning
Do you want to leave a nice financial legacy for your children and children’s children? Well, this is the best account to do that with. Ever heard of the Stretch IRA? It’s a beautiful concept. You can make a single $5,500 investment in a Roth IRA and potentially stretch it for several generations spanning hundreds of years and this single investment can compound into hundreds of millions of dollars. Don’t believe me? Well, check out the details here. This is one of the reasons why the Roth IRA should be the first place to put your retirement money in and the last place to withdraw from
#4 No Required Minimum Distributions
With your 401(k), 403(b), TSP, Traditional IRA or Rollover IRA, once you turn 70.5 years, the IRS requires you to make a mandatory withdrawal from this account (the exact amount is calculated by the IRS but is close to the 4% rule). If you have a lot of money in this type of account at that age, this mandatory distribution, called RMD, will potentially reduce the amount of money in there. Well for most people, they will likely need that money to live on. However, if you have engineered your finances well and have built a lot of wealth by that age, you may not need all the potential RMD money, yet you have to withdraw it. Well, this good problem does not arise with the Roth IRA. You can virtually decide never to withdraw any money from your Roth IRA account and eventually bequeath it to your heirs, essentially stretching the Roth IRA (see #3 above)
#5 Multiple Investment Options
The typical 401(k) or 403(b) has a few investment options (typically 10-20 options) to choose from. In my first real job, my employer’s 401(k) plan was managed by an insurance company and they had 14 investment options, almost all of them horrible. There was no single index funds and most of the active funds in the plan had very high expense ratios. Yes, I still participated in it, but it was painful to be helpless in such a situation. With the Roth IRA, your hands are not tied like that. You virtually have endless investments to choose from. But hey, don’t let the many options available lead you to analysis paralysis. Just stick with basic, low cost, total market index funds and you will live happily ever after.
#6 Simple To Open
While the trend is indeed now changing, most new employees are required to sign up for their 401(k) and there are often some boring paperwork to fill out. This often dissuaded some new employees not to sign up (bad idea!). Employers have figured this out and some are now auto-signing new employees with the option that they can opt out by going to the HR office and signing some papers. This trick actually makes some employees to sign up for the 401(k), who would otherwise not participate. It’s a mind trick and powerful aspect of behavioral finance. Well, with the Roth IRA, sign up is easy and simple. For most reputable companies, you can complete this online within 10 minutes. My default investment company is Vanguard
#7 Good for Child Investors
Do you have a child who has earned income? Or a teenager who does some summer job, cuts grass or baby sits and makes some money? Well, the best thing you can do for that child, any child who makes some money, is to help them establish a Roth IRA with their earned income. They will have to file a tax return on the money they earned. As a parent, you can help them by matching the money they earned. Personally, I think this is one of the greatest financial legacies a parent can leave a child. This is how it works: let’s say Natalie is 5 and makes $3,000 baby modeling in one year (because she is so cute and photogenic). The parent can match that $3,000 for her and open a Roth IRA account for her and stick that $3,000 into it, then help her file a tax return the following year. Imagine what compounding over 70 years will do for that money? Wanna guess? Without putting any other money into this Roth account, that single $3,000, at 9% annual compounded return, will become $1.25 million when Natalie is 75 years old! Mind blowing? Let that sink in for a moment.
#8 Serve As Supplemental Emergency Fund
If you put money into your 401(k) or 403(b) and attempt to withdraw it anytime before age 59.5, you will be penalized (10% penalty). With the Roth IRA, there is a way you can get to this money, technically. After 5 years, you can withdraw your contributions tax and penalty free. This feature potentially makes the Roth IRA function as a supplemental emergency fund. Hey, I would rather recommend everybody keep an emergency fund separate in an online savings account, but for those rare emergencies that require more than what you have there, the Roth IRA can serve as an extra buffer
#9 Great For Non-working Spouses
In America, there are a sizable amount of families that are single-income households where one spouse works and the other spouse stays home, typically taking care of the kids. It is not unusual to find such spouses go 1-2 decades without working outside the home. For such spouses, they cannot open a 401(k) and save for retirement. But they can certainly open a Spousal Roth IRA and max it out. How cool is that? CNBC calls the Spousal Roth IRA a missed retirement savings opportunity for couples. As long as the working spouse makes enough money to cover the contributions for both of them (for 2018, this is $11,000 or $5,500 for each spouse). There is simply no reason why a stay-at home spouse cannot have her own retirement account in the form of a spousal Roth IRA. My wife was still in school when I first opened a spousal Roth IRA account for her and contributed to it. I remember the pleasant feeling she had when she learnt she now had her own retirement account even before she started working.
#10 Tax Diversification
Diversify! Diversify!! Diversify!!! It’s one of the common mantras in investing. Diversification is considered the only free lunch in investing. Just because you don’t know which investments will do well in the future, it’s good to be exposed to the basic assets classes. In the same way, it’s also good to have tax diversification in retirement. So, in an ideal setting, you should have these 3 levers of tax diversification in your retirement accounts:
A. Tax-deferred traditional accounts: Your 401(k)s, 403(b)s, 457, TSP, Roll-over IRAs. These would be taxed at retirement and should be the main fulcrum of your retirement plans
B. Tax-free accounts: Essentially your Roth accounts. This helps to provide tax-free distributions at retirement
C: Taxable accounts: Your taxable investment accounts. These would be taxed annually (dividends and capital gains distribution) and also taxed whenever you sell investments inside these accounts (capital gains taxes). However the tax structure is more favorable that the income tax structure
When all of this is structured very well, you can withdraw from the 3 levers of your retirement accounts in such a way that you owe very minimal taxes every year. It’s not a complicated strategy and anybody can do it. This way, you get to control your taxes yourself.
So with these few points of mine, I hope I have convinced you that you should have a Roth IRA and if you haven’t opened one, it’s time to get cracking!
So do you have a Roth IRA? Do you have one for your spouse? If not, why not?
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