Category Archives: Retirement

MG272_IRA

Why You Should Have a Roth IRA

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.

Other Benefits

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.

AP_Logo

AP Credits Are The Best Scholarship Around

In high school I was lucky enough to already know what I wanted to major in at university, and I was pretty sure about what university I would end up going to. I was also fortunate enough to go to a school with a lot of AP Credit, which made this much easier, but it is still very possible at many high schools… Of course, as the future-obsessed, Judging-type I am, I entirely planned out my high school schedule to maximize the amount of credit I could earn towards my college degree. My thought was: If I am going to have to take these classes already, why the hell should I take them again? Just so happens that I was able to bring in 64 degree-applicable credit hours (out of 128 needed for my degree). This has given me leeway to take interesting classes, a lightened load, double minors, and still graduate a year early. But that is not the interesting part of AP classes; today we are going to look at the economic advantages of AP credit for an average student..

Requirements

Yes, you have to do a bit more work than the person next to you. But in today’s world you have to work harder and better than the person next to you in order to succeed. You won’t be rich if you don’t work hard. Period. Unless you win the lotto, but then you wouldn’t be reading this blog. Say you or your child or cousin is a high school Junior that chooses to work a bit harder than everyone else and signs up for the following AP classes:

Junior Year

  • English Language and Composition AP (>=3)
  • United States History AP (>=4)
  • Psychology AP (>=4)

Senior Year

  • English Literature and Composition AP (>=4)
  • Physics B AP (or Biology or Chemistry) (>=3)
  • Calculus AB AP (>=3)
  • Macroeconomics AP (>=4)
  • United States Government AP (>=3)

Each year you paid attention in class, studied, did test preparation, bought an AP Study book (which you read and practiced with), and took the AP tests you needed in May. You tried hard, got a little bit lucky on the grading, and made the minimum required scores for, say, the University of Texas to take your credit (those minimums are in the parenthesis).

Had you successfully followed this regimen, you would graduate high school with 32 hours at the University. Since these hours should all be applicable to (most) degrees (which is why you pick them based on your planned degree, duh), you would basically have just saved yourself a year of college.

No Tuition Paid Senior Year

This means you would have saved yourself 1x year of tuition, books, late-night energy drinks, and beer.. Since you probably borrowed against student loans to pay for this, the interest that you would have paid is also gone. So the $20,000 of expenses you would have incurred, which would have cost you about $200/month on a 3%, 10-year loan. So now instead of going to pay interest, your money gets to compound. Each month you take the $200 you would have spent on college loans and put it into a Roth IRA.

Extra Year Working

With the extra time you have in college you could work a part-time job (covering expenses), or you could graduate early. Say you had chosen to graduate a year early and start working. Let’s pretend you make the median household income with your degree ($54,000), and you lead a Mustachian lifestyle, spending only $20,000 that year. After taxes, you would be able to save around $25,000 that year, which you contributed to your 401k and Roth IRA.

Results

If you could earn a 6.5% real rate of return with both the money you would have paid to student loans and the extra money you made from graduating early, you would have $460,000 in real dollars sitting in the retirement accounts by the age of 60. You could reasonably spend $18,405/year (4%) using this money from age 60 on.

The small amount of work you put in when you were 16 paid you off nearly a half a million real dollars by the time you were 60. Using the extra cash saved from not paying tuition and being able to work 1 year earlier, you were able to generate enough income in retirement to keep you out of absolute poverty. Most people don’t think about the massive opportunity costs of their decisions when they are young, and the ones who do are usually handsomely rewarded.

RetirementLane

Only Save For Retirement For 6 Years

If you are planning on retiring much earlier than the typical person, who retires at around 60-70 years old, one thing that you have to do is plan exactly how you will access my money in retirement. My plan is to split up savings into two “buckets” – Old Money and Young Money. The idea is that my retirement accounts will be funded exactly to the point where they will provide me with enough traditional retirement income. In order to take advantage of the time value of money, these contributions only occur at the absolute start of my career, between 21-27 years of age.

Try to max out the 401k and Roth IRA when you start working. Right now the IRA contribution limit it $5,500 and the 401k limit is $17,500+Match (say, $3,000). Maxing out both of these accounts would come to a total contribution of $26,000.

Assuming 3.5% inflation, and a 6.5% after-inflation rate of return (this is the 100 year annualized market return and inflation value), after 6 years of contributions I should have approximately $227,000 in the accounts ($180,000 after inflation). Assuming that I stop making any contributions at age 27, and the accounts can grow at the same rate of return until I reach traditional retirement at age 60, the accounts would be worth nearly $5 million nominally. In today’s dollars, it would be worth nearly $1,400,000 and it would produce about $56,000 in annual income before tax.

That seems like a great deal doesn’t it? All you would have to do is max out the accounts for just 6 years, allow compounding to do the rest, and be able to enjoy the median household income every year once you reach 60.

In practice, however, the opportunity cost of taking money out of these tax advantaged accounts is relatively high, and you might be inclined to not take withdrawals until age 65 or even later. In our scenario, those extra 5 years of compounding could create nearly $500,000 in real extra wealth, which would allow someone to spend $75,000 annually in traditional retirement.

The Other Way Around

In reality, what one should do is work backwards using some initial targets in order to determine what their savings level needs to be. For example, if your goal was to have $100,000 in annual passive income from your retirement accounts by the age of 65, you would do the following calculations:

$100,000 in Annual Passive Income

/ 4% = $2,500,000 in today’s $ needed

* (1.035^45) = $11,800,000 in 2058 dollars needed (inflation)

/ (1.1^35) = $420,000 needed to be invested by age 30

pmt(10%, 10, 0, $420,000) = $26,000 needs to be saved annually for 10 years.