What is a Roth IRA?
A Roth IRA is an individual retirement account (IRA). A traditional IRA and a Roth IRA are similar in that they both allow you to save designated funds for retirement. The key difference is the tax treatment for each account.
Traditional IRAs allow you to contribute to your personal retirement account. When you contribute you are allowed to take a tax deduction for your contribution amount in the year you contribute. When you withdraw the money in retirement you owe income taxes on the amount withdrawn. A Roth IRA offers you no tax deduction for the year you contribute. However, when you withdraw the money in retirement everything comes out tax-free. No tax is due.
How much can I contribute to a Roth IRA in 2021?
Your total contributions to all of your traditional and Roth IRAs cannot be more than $6,000. If you are age 50 or older you may contribute an additional $1,000 catch-up contribution. You cannot contribute more than your taxable compensation limit for the year.
There are limits as to how much you can contribute based on your income limits. Since the limits change each year the best strategy is to check with the IRS for the most up-to-date limits and amounts. You may visit the IRS resource here.
A simplified comparison between Traditional and Roth IRAs
John and Ted are twins. Both are age 20 and have jobs that pay $50,000. In 2020 that puts them in the 22% tax bracket.
John hates paying taxes. He decides to contribute $6,000 into a traditional IRA. As such he doesn’t have to pay taxes on the amount contributed. He lowers his tax bill this year by $1,320 ($6,000 * 22%).
Ted decides to take the long view. He puts $6,000 into a Roth IRA and gets no tax benefit this year.
They both never contribute to the IRAs again. Thanks to some luck in investing both have grown their IRAs to $500,000 by the time they are 60.
To celebrate their good fortune, they choose to withdraw the entire accounts so they can purchase a vacation home together.
In 2060 tax rates have risen quite a bit so the government can pay down the deficit. A single earning $500,000 is in the 50% tax bracket.
John pulls out his $500,000. Since he had the traditional IRA, everything is taxable too him. He pays the IRS $250,000 ($500,000 * 50%). He has less than he thought to put towards the vacation home but is pleased that his account has grown so much.
Ted pulls out his $500,000. Since he had the Roth IRA, he owes no taxes on his withdrawal. He pays the IRS $0. By paying the extra $1,320 in tax 40 years ago he has $250,000 more than his brother.
What are the best investments for a Roth IRA?
The key takeaway is that it is in the investor’s best interest to grow their Roth IRA as much as possible over their lifetime so they can create the highest tax-exempt value as possible.
There are two ways to make this happen. Increase the time horizon and increase the rate of return.
To have the most time to grow you can obviously start early. However, you should also structure your withdrawal strategy such that the Roth IRA is the last asset you touch. You don’t have to take required minimum distributions (RMDs) from a Roth IRA so this account should be the last asset you spend.
To increase the rate of return you need growth instruments. This is why I recommend Roth IRAs should be invested solely in the stock market with very few exceptions. That’s right – 100% in stocks.
The main exception to this rule would be if it skews your overall household asset allocation to an allocation too risky for you. If you have other accounts (401k, traditional IRA, taxable accounts) use those to hold the more conservative fixed income investments. If the Roth IRA is so large in dollar terms compared to the other accounts, you may be forced to put more conservative investments there to ensure your overall household asset allocation meets your risk tolerance.
How do I get started with a Roth IRA?
For those new to investing you can visit our prior blog: “How Do I Get Started Investing?”
I have more questions. What do I do next?
If you’d like to discuss how to utilize a Roth IRA to your benefit you can schedule an introductory call with us using this link:
Birch Investments is a fee-only financial planner based in South Dakota. We serve clients nationwide virtually.