Millionaire Rule #8

Fund a Roth IRA to the Limit
The Roth IRA is my second favorite type of account for retirement saving. Because I'm the type of guy that really gets excited about the prospect of have a massive amount of money in retirement, it means that I REALLY love the Roth IRA. If you are curious what my number one favorite type of account is check out Millionaire Rule #7. My goal for this post is for at least half of those who read it to get fired up and open a Roth IRA in less than 24 hours from reading this post. Now, to explain why a Roth is so great.

First, we have the benefit common to all forms of IRAs, tax free compounding. That means from year to year an investor does not have to pay taxes on the income generated within the account. So for example consider the following sequence of events: you use the money in your IRA to buy some stock, the value of the stock goes up, and then you sell it for a profit. In a normal taxable account when you file your taxes the IRS will want its share of your profits (called capital gains) which can range from 15% (shares held more than a year) up to 35% or the top income tax rate (shares held less than a year). The tax man would also stick his hand out for income generated from dividends and interest (at the top tax rate) as well. Obviously these taxes can be a massive drag on your portfolio except that an IRA keeps the money safe from Uncle Sam.

The money stashed in a Roth is after tax dollars which means you can not deduct your contributions from your income when it is contributed; while on the other hand, a Traditional IRA is tax deductible. This may seem like a bad thing, except to make up for it, when money is withdrawn from the Roth it is tax free. Yep, as amazing as it sounds, all of the money you manage to build up (from both contributions and earnings) in your Roth IRA is completely tax free when withdrawn in retirement. Zero taxes in retirement give the Roth IRA a huge advantage in my retirement planning strategy.

The next great thing about an Roth IRA is that it allows you to shelter more money from taxes than a Traditional IRA. The reason is slightly complex, but here it goes. Both accounts have a maximum contribution in 2008 of $5,000. I already explained how a Roth is after tax income and a Traditional IRA is pretax income that is taxed instead at withdraw. So the effective amount of savings in a Roth that are sheltered from taxes is the full $5000 (post tax) based on an investment of $6666 in pretax dollars. The Traditional IRA can take a $5000 pretax contribution but will only be able to ultimately shelter $3750 because that $5000 gets taxed at withdraw in retirement. If that is confusing keep on reading.

Here is an example, we start with the same $5000 investment and assume the 25% tax bracket both now and in retirement. The Traditional IRA will get a contribution of the full $5000 and then compounds until retirement. At retirement the money is withdrawn and the 25% tax is paid. The Roth will get a contribution of $3570 (remember it is after tax so $5000 * 0.75) and then compounds until retirement where it is tax free. In this scenario both types of account wind up with the exact same amount of spendable cash in retirement (take the tax before or after it is all the same). However, if you have $6666 that you are able to save, you can put the full $5000 into a Roth you will end up with more money tax free in retirement. In effect, the Roth is able to shelter 25% more money from taxes than the Traditional IRA (assuming you have the extra money to save).

Tax rates change over time. Many people believe (and history would seem to support) that current tax rates are well below their normal levels. Many people (myself included) also expect to be in a much higher tax bracket in retirement than they are now. Early in a person's career they may have a lower income coupled with tax deductions for mortgage interest, dependents, and student loan interest that will disappear by retirement time. I expect to go from the 25% tax bracket now to the 35% bracket in retirement (I'm ambitious what can I say?). A Roth IRA protects your retirement income from the risk of higher tax rates in the future. That means a Roth IRA effectively adds 10% on to its value relative to other tax sheltered retirement accounts like a 401(k) or Traditional IRA for someone like me.

The Roth IRA has a few more benefits I just want to quickly address. The contribution maximum is index to inflation so the amount you can save will increase over time. Roth IRAs are given special treatment in the unfortunate even of their owner's death. A non-spouse inheritor can take withdraws from the Roth over the course of their lifetime while maintaining the tax deferral of capital gains and interest. Normally stocks, bonds, or 401(k)s in an estate incur the full tax burden at the time they are inherited (so no continued tax free growth). Lastly, Roth IRAs can be opened with many different banks and brokerages which provide a massive selection of possible investments. Individual stocks, bonds, options, commodities, futures, mutual funds, ETFs, real estate, art and darn near any thing else you can think of can be used an investment in a Roth IRA. This is very different from a 401(k) which is limited to a single management company selected by the employer and only a limited selection of mutual funds in which to invest. Investments in the Roth can cover all asset classes and are completely controlled by the investor.

It may seem like this list could go on and on, but I have one last special benefit of the Roth IRA. Because the contributions to the account are after tax, there are no penalties or taxes from withdrawing your contributions from the account in the event of an emergency. This is very different from a 401(k) where pulling money out before age 59 1/2 would result in paying taxes on the withdraw plus a 10% penalty. The Roth IRA does not have this problem, and it can give you extra piece of mind and a source of cash in a pinch. I really recommend you stay out of your retirement funds if at all possible but at least you know it is there if you need it.

I've covered most of the great benefits of the Roth IRA. In all honesty there aren't many drawbacks. Over 40 years of contributions at the $5,000 and earn an 8% return your account will grow to over $1.4 million. I highly recommend the Roth IRA as Millionaire Rule #8. Check out the rest of the Millionaire Rules and be sure to subscribe to my RSS feed.