Whenever my peers tell me that they are interested in getting started in investing, I almost immediately ask them if they have a Roth IRA. Once I explain that the Roth is an Individual Retirement Account, their usual response is something like, “why would I open a retirement account? I hardly have any savings anyway, and I can’t afford to put my savings out of reach in case of an emergency..” While it is absolutely true that you should have about 6 months of expenses held in an interest bearing account (or highly liquid T-bills) before you start investing, you can still open a Roth IRA and use it as a much more powerful savings account.
First, we need to cover some of the basics regarding the Roth IRA. A Roth is designed for long-term investing for retirement, and thus is given a generous tax treatment from the government. Essentially, you are not taxed on any interest, dividends, distributions, or capital gains in the account each year. This is a huge deal! The frictional effect of taxes on long term gains is astounding (especially if you are buying a blue-chip dividend stock and are reinvesting the difference). As an example, assume you purchase a stock that pays a $4 dividend (which increases at a 3.5% rate of inflation), reinvested the dividends, and the stock stays fairly valued at a 3% dividend yield, in both a taxable and non-taxable account. All things equal, your annual effective rate of return over 15 years in the taxable account would be 5.8% versus 6.6% in the non-taxable Roth IRA. That doesn’t sound like much, but it means you would be 20% richer after 15 years! Again, non-negligible. For this reason, many advisers suggest investing in high-yield dividend stocks and normal bonds in a non-taxable account — while making more speculative capital gains plays or non-dividend stocks in taxable accounts (assuming both are fully funded – obviously a non-taxable account is always better for returns).
The tradeoff here is that, unlike a 401k plan, you don’t receive any sort of tax break for contributing money to the account. So each dollar that is in the account has already had taxes paid on it once — but then compounds tax free. There is all sorts of calculators to determine what the exact return differences are based on your tax bracket and situation, but that isn’t the point of this article.
Can I get my money out?
One of the common misconceptions around is that you “can’t get your money out” of a Roth IRA – which couldn’t be further from the truth. In fact, you can withdraw any or all of the principal at any given time. Any dollar that you contributed can be removed at any time, without penalty or taxes! The penalties & taxes come in when you try to withdraw gains from the account before the age of 60 — I believe those gains are counted as income on your tax return, and you are subject to a 10% fee. This isn’t as big of a deal as you may think.. If you have an emergency in the first few years and need to take out cash, you likely won’t have much gains anyway — and the opportunity cost of removing these funds would be exceptionally high. If you had bought AAPL in 2001 at around $8 and sold it at $700, thus striking it rich, you would have several options… You could withdraw the funds early and paying the taxes and 10% fee, withdraw some of the money to purchase a house (among several other legitimate un-penalized withdrawals), or just stop saving for retirement entirely and let the balance compound.
Basically, you can contribute up to $5,500 in the Roth IRA this year and be able to withdraw that principal on demand at any time, tax and penalty free. This, along with the preferred tax treatment, makes the Roth IRA a great place to start for a burgeoning investor.
Another great benefit of the Roth IRA is that there is no Required Minimum Distribution during your lifetime – meaning that you are not required to withdraw money each year after the age of 70 (like you are with a 401k plan). When you die, the account can be assigned to a beneficiary (who pays a reduced estate tax on the amount) and has a choice of taking distributions their whole life This makes the account invaluable as an estate-building tool, especially for higher-income households.
For example, assume that the Roth IRA were to continue to raise it’s contribution limit of $5,000 at an inflation rate of 3.5% indefinitely. At start of each year, you max out the contribution and invest in a variety of stocks, earning a long-term return of 10% (6.5% after inflation). Continue doing this from age 20 to age 85, and the ending account balance would be $4,349,950 in today’s dollars (or, get this, $40,701,187 nominally). The beneficiary would be required to distribute the account balance divided by their remaining life expectancy. For example, if you gifted this account to a 30 year old, he would be required to take a minimum distribution of $83,014.33 in today’s dollars. Not a bad haul! Even better, you could set up a trust fund, naming your great-grandchildren as the beneficiaries. Over the course of the life of your oldest grandchild, RMD would be taken from the account to be placed into the trust to compound and be dispersed. For example, if you did this with a 1 year old child, and took the RMD, and placed it in a trust fund earning 8% until they were 30, you would have about $7.1 million 2013 dollars in the trust, and $17.9 million 2013 in the Roth to keep distributing to the trust.
Not to get too much into this, but if you had been distributing 4% from the trust while doing this process starting at age 18 and going until the oldest beneficiary was 60, you would have a combined $123 million today’s dollars in the trust and Roth, and have distributed over $37.6 million to your inheritors.
The point being that the Roth can theoretically be used to compound your wealth, while keeping the money in your pocket, rather than Uncle Sam’s.
What are the requirements?
Well, first off there are income limits dictating who can contribute to a Roth. Next, you can only contribute a maximum of $5,500 this year. Also, you must have had earned income during the year (which you paid taxes on), and you can’t contribute more than this number.
How do I get one?
It is really easy to open one of these at a discount broker like Charles Schwab, TD Ameritrade, or Vanguard. Just go to their websites, look for the Roth IRA and open an account. I highly, highly recommend college students opening an account, since they have the most time to leverage the astounding benefits of compounding.. Usually these places have minimum contributions (around $500 or so), so make sure to have enough cash on hand before you contribute. Since it is not a particularly nice process to withdraw from the Roth, try not to deposit so much that you will need to be depositing & withdrawing all year.