Why You Need a Roth IRA
(Hint: It Could be Worth Millions)
Do you need a Roth Individual Retirement Account (IRA)?
The short answer is that, in almost every case, if you are eligible, you might be missing out if you don’t.
In fact, without knowledge of how you can maximize the power of this type of individual retirement account, you might be leaving a lot of money on the table. How much money? Believe it or not, in some cases, it could amount to thousands or even millions of dollars.
Do you think that a Roth IRA might be appealing to you? If so, read on. We’ll educate you about Roth IRAs and show you how easy it can be to set one up and take advantage of its many benefits.
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What is a Roth IRA?
IRAs were created by the federal government to encourage people, especially those who don't have workplace retirement plans, to save for their own retirements rather than become a burden on society. However, if you know and follow certain rules, you can contribute to an IRA even if you do have a workplace retirement plan!
Broadly speaking, IRAs come in two types: traditional IRAs and Roth IRAs. The traditional IRA is generally funded with pre-tax money, meaning that you save taxes when you make the contribution. However, when you later begin withdrawals from a traditional IRA, you must pay taxes on your distributions including on all your gains. Additionally, you must begin taking money from the traditional IRA when you reach the age of 70 ½ because the government eventually wants to collect its share of the taxes you owe. And if you need money from a Traditional IRA before you turn 59 ½ you have to pay an additional 10% penalty in addition to the taxes that would be due on your withdrawal.
In this article, however, we are going to focus on the Roth IRA, mainly because of its even more generous wealth-building provisions. With a Roth IRA, you contribute money you’ve already paid taxes on for the calendar year of your contribution, but when you withdraw, potentially many years later you pay no taxes on any of the gains. In addition to the tax-free withdrawals there is no requirement to begin withdrawals at a specific age. Indeed, the Roth IRA offers the ability to pass on the IRA value to heirs tax-free.
The combination of tax-free growth, no taxes due upon withdrawal, and no minimum age of distribution make the Roth IRA a powerful investing tool, especially for affluent and high income families. Used properly, and combined with great investments, the Roth IRA’s potential to save you taxes over an extended investment horizon can enable you to harness the power of investment compounding to potentially build the value of your account over time into millions of dollars in tax-free gains.
History of IRAs and Roth IRAs
Prior to 1974, IRAs did not exist. In that year, Congress passed the Employee Retirement Income Security Act (ERISA), and the original version of the IRA was established.
Over time, numerous congressional actions expanded the utility of IRAs. In particular, the Economic Recovery Tax Act that was passed in 1981, made the IRA more widely available and increased the maximum annual contribution.
Congress established the Roth IRA in 1997 after Republican Senator William Roth of Delaware proposed it as a way to encourage a culture of saving rather than spending.. Its generous provisions, described above, are so different from the original IRA that the older version became known as a Traditional IRA.
Both types of IRAs have become very popular. Today, it is estimated that IRAs hold more than $9 trillion, representing almost one third of all US retirement plan assets.
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Benefits of Roth IRAs (You Will Like These!)
Keep in mind that a Roth has many benefits that are not part of the rule-structure governing traditional IRAs, especially when you withdraw money: Roth withdrawals are generally tax-free! This beautiful benefit means that, as mentioned, if you start early and put the power of compounding to work, you can amass and keep 100% of a hefty nest egg as you approach retirement age.
Another Roth IRA feature is that there are no required minimum distributions, as there are with a traditional IRA. We’ll cover some of the ramifications of these provisions in the upcoming “Roth Tips” section.
A comparison of the wealth-building advantage of a Roth IRA versus a traditional IRA can illustrate the power of the Roth IRA. Let's assume someone saves $5000/year for 30 years and that the account grows at 8% per year. This amount of growth would give you a sum of $625,123 (and save you $37,500 in taxes over the 30 years). With a Roth IRA, you can take that whole sum tax-free. Assuming a tax rate of 25%, the traditional IRA net benefit to the account owner after taxes would be significantly less, at $468,842. Given higher contributions, higher investment returns, and more time, the difference can be millions!
Setting Up Your Roth IRA
It’s relatively easy to establish a Roth IRA. First, determine that you are eligible based on your income (AGI). After that, you’ll need to find a custodian for your IRA, fill out required paperwork, and fund the Roth. Of course, investment advisors like Ridgewood Investments can assist you with all of these steps and even more importantly advise you on what investments can be used to maximize the growth of your contributions over time.
- Tip #1: One of the best tradeoffs that a retirement investor can make is, under the right circumstances, to convert a traditional IRA to a Roth. The best circumstance to do this may be if you have negative earnings on your traditional IRA. You can make the conversion, pay taxes on the pre-tax principal contributions (best done from other personal sources rather than from the original IRA itself), then convert it to a Roth IRA and reap its generous benefits.
- Tip #2: Use the Roth IRA as a generational wealth pass-through fund. If your retirement needs are sufficiently met by other sources of income, simply let the Roth keep growing in value. Indeed, there is no provision that you ever need to withdraw from your Roth IRA during your own lifetime. Upon your death, the whole sum can be passed on to your designated heirs income tax free
- Tip#3: Since the greater the growth of the Roth IRA the greater the tax savings you will benefit from, make sure that you select investments for your Roth IRA that offer you the possibility of good long-term growth. This can mean to favor stocks or other growth investments rather than lower-returning or conservative investments such as bonds and money market funds. This type of analysis is called “asset location” and a good investment advisor can help you make sure that your investments are placed in the right type of account within your overall portfolio.
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Of course, even with something as well designed as a Roth IRA, there are a few pitfalls to be aware of. One is the Roth 5-year rule. This rule states that in order to receive tax-free withdrawals, you must have your contributions in a Roth IRA for at least five years and be 59 1/2. Otherwise, you may be liable for taxes on your gains as well as a ten-percent penalty. Be sure that you will not need to withdraw gains from your Roth conversion for at least five years.
Some folks may balk that you must pay taxes up-front when you make your contributions. Once you recognize the myriad of benefits, most astute investors stop thinking of that as a pitfall.
One important limitation to be aware of is that only people with income under specific amounts can contribute directly to a Roth IRA. You cannot do so if your adjusted gross income (AGI) in 2019 is greater than $203,000 (married filing jointly). Also, if you do qualify to fund a Roth IRA, the maximum amount that you can contribute in 2019 is $6,000.
Fortunately, there is a workaround for bypassing this income limit by using are more advanced strategy known as a “Backdoor IRA”. Especially useful for high-income workers, this technique basically involves contributing to a traditional IRA first and then rolling that contribution into a Roth IRA (and paying the relevant taxes due upon conversion). Once again, experienced Investment advisors such as Ridgewood Investments can guide you through every step of the “Backdoor IRA” process.
Ridgewood Can Help!
As you can see, a Roth IRA can be a fantastic wealth-building tool if you combine its tax benefits with great long-term investments. Matching up the Roth IRA with a portfolio of securities that can deliver growth as well as provide risk mitigation is critical. You also need to be aware of all the rules and provisions governing the Roth and potentially other IRA types because any mistakes with the process can set you back or lead to substantial penalties.
Ridgewood Investments focuses on growing and preserving wealth by tried-and-true long-term diversified investment methods. If you could benefit from some expert advice on maximizing the benefits you get from powerful tools like the Roth IRA - Ridgewood can help! Contact us or schedule an appointment to chat about your own unique situation.
About the Author
Kaushal “Ken” Majmudar, CFA founded Ridgewood Investments in 2002 and serves as our Chief Investment Officer with primary focus on managing our Value Investing based strategies. Ken graduated with honors from the Harvard Law School in 1994 after being an honors graduate of Columbia University in 1991 with a bachelor’s degree in Computer Science. Prior to founding Ridgewood Investments in late 2002, Ken worked for seven years on Wall Street as an investment banker at Merrill Lynch and Lehman Brothers where he has extensive experience working on initial public offerings, mergers and acquisitions transactions and other corporate finance advisory work for Fortune 1000 companies. He is admitted to the bar in New York and New Jersey though retired from the practice of law.
Ken’s high level experience and work with clients has been recognized and cited on multiple occasions. He is a noted value investor who has written and spoken extensively on the subject of value investing and intelligent investing. He has been a member of the Value Investors Club – an online members-only group for skilled value investors founded by Joel Greenblatt, SumZero – an online community for professional investors, and has also written for SeekingAlpha – among others. Ken is active in leading professional groups for investment managers as a member of both the CFA Institute and the New York Society of Securities Analysts.