Happy Roth New Year!
Happy Roth New Year! I like to celebrate the start of the new year by making a plan to make the maximum Roth IRA contribution for the year. As a 28 year old, I have likely added a minimum of $65,000 to my retirement nest egg based on a 7% expected real rate of return over the next 40 years by making just a $6,000 contribution. If you began contributing the max amount to your Roth IRA as a 22 year old, your contribution would likely be worth $100,000 at retirement! The power of compounding interest is magic when properly used to your advantage. The graphic above illustrates how much a $6,000 investment will grow assuming a 7% rate of return. Investing heavily, as early and as often as possible, is truly the key to building wealth.
The act of investing is similar to a muscle that needs to be worked out on a regular basis. Consistent investment into vehicles such as the Roth/Traditional IRA, 401(k), and Taxable Brokerage accounts is what builds wealth in the long run. The intense focus on gaining more income (or spending less of what you have!) in order to consistently invest is far more efficient than debating on whether to invest in individual stocks (no matter how cool you think they are... I'm looking at you Tesla). When asked specifically about my stock preferences, my answer is always the same; consistent investment in broad based ETFs or Index funds will always reign supreme as a successful long term strategy.
IRA stands for Individual Retirement Arrangement and are commonly referred to as Individual Retirement Accounts. Anyone can open one as long as you or your spouse has earned income. You can only make contributions that equal the floor of your income, and only up to: $6,000 for those under 50, and $7,000 for those 50+ in 2022. You can open an IRA at almost any brokerage firm (ie. Vanguard, Fidelty, Schwaab, etc.) with little effort. Here are the Roth IRA contribution income phase out ( when you start to become ineligible to contribute) ranges for 2022:
$129,000 to $144,000 - Single taxpayers and heads of household
$204,000 to $214,000- Married, filing jointly
$0 to $10,000 - Married, filing separately
The phaseouts for eligibility to contribute to a Traditional IRA are a little bit more complicated:
$68,000 to $78,000 - Single taxpayers covered by a workplace retirement plan
$109,000 to $129,000 - Married couples filing jointly. This applies when the spouse making the IRA contribution is covered by a workplace retirement plan.
$204,000 to $214,000 - A taxpayer not covered by a workplace retirement plan married to someone who's covered.
$0 to $10,000 – Married filing a separate return. This applies to taxpayers covered by a workplace retirement plan
At your workplace there is a likely a 401(k) plan. For government employees, this is the Thrift Savings Plan (TSP). This plan should have a traditional and a Roth option. The same analysis applies when thinking about your current and future tax rates, but there are no income restrictions on these accounts so you want to take full advantage of these if your workplace allows it. The maximum contribution you can make in 2022 is $20,500 and many employers will match your contributions based on a percentage of your salary (usually around 5%). In fact, getting that 100% return on your money in the form of that match is the first thing you should do, then go max out your IRA, then come back to this 401(k) and max this thing out.
Roth Vs. Traditional Accounts
So, by now you might be wondering which type of Roth IRA is right for you. First, both Roth and Traditional accounts require you to leave your investments in the account until you reach 59.5 years old. Of course, you can withdrawal money prior to this age, but you will incur a 10% penalty unless you withdraw funds due to a few specific circumstances. With an IRA, you can withdraw your contributions at any time (not earnings), but I do not reccomend this as it can drastically decrease your long term wealth.
Now, onto the differences between each type of account. Roth IRA or 401(k) is typically best for those who believe they will be in a similar or higher tax bracket in retirement. In other words, if you plan to live off of your investments in retirement and the distributions from your investments are greater than your former (or current) income- then you will be in a higher tax bracket in retirement. Thus, you should opt to pay taxes on your contributions now, rather than later, while you are still in a lower tax bracket. The second type of account is the Traditional IRA/401(k). This type of account is essentially the inverse of a Roth account. Contributions to a Traditional Roth/401(k) are tax deductible in the current year and grow tax free within the account, but your withdrawals during retirement are taxed at ordinary income tax rates. This type of account is suited for those who believe they will be in a lower income tax bracket in retirement than they are in now. An example of this is a high income earner of $500,000 who projects to have an income of maybe $100,000 in retirement. He or she is ineligible for a traditional IRA, but would want to utilitze the Traditional 401(k) at work to get a tax break while they are in that higher marginal tax bracket. Below is a quick visualization of current federal tax brackets in 2022:
Despite the pros and cons of each type of account, I typically lean towards the Roth IRA/401(k) for a few reasons:
The devil you know (current tax rates) is better than the one you don't know (future tax rates). If you think your future tax rate will be anywhere near your current rate, it is best to pay the tax now. Additionally, taxes are used to pay off federal debt, and tax rates will likely have to rise in the future in order to combat the ever increasing federal debt. Congress hasn't run a balanced budget in the last two decades. I don't have a crystal ball, but current recorded tax rates are historically low, so I want to take advantage of paying taxes at these rates while the opportunity exists.
A Roth account can grow indefinitely! Once you roll over all Roth 401(k)s to your Roth IRA, the Roth account will not require Required Minimum Distributions (RMDs) in retirement, contrary to that of a Traditional IRA or 401(k). A RMD requires that the account holder, beginning at age 72, must take distributions (also referred to as withdrawals) from their Traditional accounts. Essentially, the government is forcing you to pay income tax because the IRS wants to collect revenue on the deferred tax liability (remember- withdrawals from Traditional IRA are taxed, rather than the initial contributions). Since you pay taxes on your contributions to your Roth account, meaning the IRS has already collected their payment from you, you are never forced to take distributions from that account.
The Roth account provides both income flexibility, and retirement portfolio diversity. Imagine you have a $3,000,000 Traditional IRA and you withdraw $120,000 per year for retirement income. Out of the goodness of your heart, you decide you want to help out your child by buying them a new car worth $40,000. You are going to have to withdraw more than $40,000 extra from your account due to taxes. If you owe 20% tax on that money, you will need to withdraw $50,000 and will have the $40,000 only after paying $10,000 in income tax. You also will be increasing your taxable income that year by $50,000, potentially pushing you into a higher tax bracket unwillingly. However, if you were to have $3,000,000 in your Roth account, you can withdraw any amount, at any time after 59.5 years old, and have no effect on your taxable income for the year. The Roth accounts give you more control over your taxable income in any given year and thus the ability to lower your lifetime tax bill.
Utilizing a traditional IRA or 401(k) results in a tax deduction for the current year. This tax deduction usually results in a larger refund at tax filing time. Unfortunately, the vast majority of people will squander this money on impulse purchases rather than choosing to invest it wisely. By using a Roth Account, you are forcing yourself to pay taxes now and effectively taking the temptation away to spend any excess tax savings.
Strategies for High Income Earners
If you make more than the above limits to contribute to a Roth or a Traditional IRA, congratulations! However, there are more ways for you to get money into a Roth account and grow it tax free. You have 3 main options:
Backdoor Roth Conversion: If you have no funds currently in Traditional IRAs, this works best as you can avoid the Aggregation Rule. If you make a non-deductible contribution to a regular IRA, then immediately transfer that to a Roth IRA, you have successfully completed a Backdoor Roth conversion. These are under scrutiny from the IRS, especially for the highest income earners. Consequently, I would continue to take advantage of these while they are available! Make sure your tax preparer is aware of these actions and is filing a Form 8606 with your tax return to keep track of these non-deductible IRA contributions.
Mega Backdoor Roth Conversion: This is a good way to put away serious money for retirement. In 2022, this type of conversion would allow you to put up to an extra $40,500 in your 401(k), and transfer all of that money into a Roth account. First, check with your employer 401(k) plan to see if it allows after tax contributions and either in-plan rollovers or in-service withdrawals. You would contribute after-tax dollars from your salary to the 401(k), then immediately roll those funds over to a Roth 401(k) or do a trustee to trustee transfer to your Roth IRA. This is a bit more complicated, so do your research and talk it over with your financial advisor or CPA before taking action.
Nondeductible IRA Contributions: A non deductible Traditional IRA contribution does not yield any tax deductions or tax break on the withdrawal, but your money does grow tax free inside the account. If you believe with a high level of certainty that you will be in a relatively lower tax bracket when you retire, then this strategy may be for you. These contributions need to be tracked very carefully and reported on your tax return every year with form 8606. The earnings portion will be taxed as regular income when you withdraw these funds in retirement. Without careful bookkeeping, you could end up paying tax on your contributions as well, so this strategy needs to be taken with caution and attention to detail. Depending on your situation, paying capital gains tax associated with a regular taxable brokerage account might be more advantageous (less money out of your pocket and less headache of paperwork) than the taxes paid on a Traditional IRA withdrawal. The best answer for you and your situation depends on many factors and should only be decided after talking with your financial advisor and CPA.
Investing Beyond Retirement Accounts
The new year is the perfect time to assess your projected income for the year and what kind of investing you can (and should) do outside of retirement accounts. For example, if you have already allotted funds to contribute the maximum amount to both your IRA and 401(k) accounts, but still have $6,000 in projected positive cash flows, consider setting up a monthly contribution of $500 to a brokerage account. This account will not have tax advantages, but you can contribute as much as you want and build wealth that is available to use long before retirement. Another good option is to setup automatic contributions to a Health Savings Account (HSA) if you are eligible. You have to have a High Deductible Health Plan which is defined as a health plan with a $2,800 deductible for a family and a $1,400 deductible for a single filer. Single filers can contribute up to $3,650 and families can contribute up to $7,300 in 2022, with an extra $1,000 catch up contribution available to those that are 55 and older. These accounts give you a tax deduction on the way in, grow tax free forever, and are tax free when taken out for qualified medical expenses. That's triple tax savings! These acconuts can even be used for non medical expenses after age 65 and are treated like Traditional IRA withdrawals. Putting contributions into these accounts on an automatic schedule will allow you to build wealth with very little effort, removing conscious action (or inaction!) and emotion from the equation. It will also allow you to dollar cost average, a term used to describe purchasing shares over time at set intervals. Dollar cost averaging ensures that you are consistently investing rather than attempting to time the market, which has proven to be a losers game.
Whether you are investing in a Roth or Traditional IRA, 401(k), a taxable brokerage account, an HSA, or all of the above the important thing is to have awareness of where your extra cash flow is going and to be intentional about consistent, disciplined investment. This will allow you to reap the magic of compound interest over long periods of time to build wealth and reach your financial goals.