At the beginning of every year I get a bit obsessed with financial checkups. I set goals for the year and run a bunch of scenarios to see how I’m doing. (You can probably tell based on yesterday’s post about how to balance living now versus planning for later…). Each of the last handful of years has involved maxing out IRAs for my wife and me along with my 401(k) (my wife stays home with our kids). And each year I fall more and more in love with my seductive mistress… the Roth IRA.
If you don’t have one set up, now is the time to do it. For those of you who are new to the money game, a Roth IRA is a retirement account that encourages people to take some of their retirement into their own hands by giving favorable tax treatment to investment gains.
Here are some Roth IRA basics. I’ll try and keep this as short as possible… But it’s tough when there is so much to love 
First, you can set it up with pretty much any online discount broker. I use TD Ameritrade for no particular reason other than I have one of my investment accounts there and they have no fees. Scottrade also has low or no-cost Roths. Vanguard and Fidelity are also well regarded.
Second, you can put in up to $5,000 per year if you’re under 50 and $6,000 per year if you’re over 50.
Third, you cannot deduct the contributions from your taxes. That means you contribute with after-tax money.
Fourth, there are income limits on contributing to Roth IRAs (basically phasing out between $110,000 and $125,000 for single filers and between $173,000 and $183,000 for married filing jointly). But there are no limits on converting traditional IRAs to Roths, so the income limits have little bite anymore (high income earners have been contributing to a traditional IRA, not deducting the contributions (because they are subject to phase-out) and then converting to Roth. Tada!)
Fifth, you can still make contributions for last year. You have until taxes are due to contribute. This year it’s April 17. But don’t wait until the last minute. You don’t want to miss out because of a bank delay or something like that. The point is you can still get $5,000 in for 2011 now.
But none of those are why I love Roth IRAs. Here are my top three:
Taxes. Remember me mentioning you can’t deduct the $5,000 you contribute? Well that’s the last time you’ll pay taxes on Roth dollars unless you go crazy and withdraw gains before you turn 59.5. Once you hit 59.5 you’re tax free. That’s right – no capital gains, no income taxes.
Consider a hypothetical person who invests $5,000 per year from age 25 to age 60 and mirrors what the Dow Jones Industrial Average did for the last 20 years as a return, reinvesting dividends. They would have invested (and paid taxes on) $175,000. But your balance would be about $1.3 million. That means you get $1.125 million dollars tax free. Also, under some circumstances (including to buy or build a first home) some contributions can be withdrawn as long as the money’s been there for five years without tax problems. Convinced yet?
Investment Choices. 401(k)s are great because you can stash $17,000 per year into retirement. But your investment choices are generally limited to whatever mutual funds some goober decides are right for you. Generally they give you one or two choices in different “categories.” Some 401(k)s allow you to choose investments for a pretty hefty fee, but for the most part you’re stuck with some pretty crappy choices.
Roth IRAs let you choose basically whatever you want – any mutual fund, any ETF. More control.
Higher “effective” contribution limits than other IRAs. This is so important that I separated it out from the “tax free gains” reason I love Roths. It boils down to this: Traditional IRAs have the same $5,000 limit but reverse the tax treatment of the contributions. You generally contribute with “before tax” dollars. So comparing $5,000 in a Roth with $5,000 in a Traditional IRA is not comparing “apples to apples.”
Here’s how it works: Assuming you’re in the 25% tax bracket you have to make $6,667 in order to have $5,000 after-tax to invest in a Roth. That’s your “apples to apples” number. So basically you’re “sneaking” more money into retirement because of the tax treatment. This in combination with the “never pay taxes again” likelihood makes Roth melt my heart.
Babbling Tangent:
What about a matching 401(k)? Most people agree that a matching 401(k), despite its limited investment choices, trumps a Roth IRA but only up to the match. I don’t have that option, so the Roth is my one true love. If you have a matching 401(k), however, consider investing up to the match and then pile-driving a Roth IRA as much as you can.
Don’t get me started on a Roth 401(k)s, which combine most of the best Roth IRA features with the higher $17,000 limit. Those rock despite the limited investment choices.
And if you have a Roth 401(k) with a match consider open mouth kissing whoever made that decision, haha… seriously, don’t open mouth kiss anyone at work (even if you work with your spouse… wait until you get home, ok?). But you get the point. Even though the “matching” amount has to be put in a traditional 401(k), you’re set up to retire like a king or queen on just $17,000 per year out of your pocket (about $4.4 million tax free).
OK. I’m back from my tangent. Here’s the bottom line:
Want to set up a retirement plan that rocks? Consider maxing out a Roth every year and investing in simple index funds auto-reinvesting the dividends. It’s simple. It’s tax advantaged. It’s flexible. And if you’re married filing jointly, you can get $20,000 in as long as you act fast (2011 and 2012 contributions for you and your spouse).
Anyone else as enamored as me?
Until next time, put your credit card down and slowly step away from the mall!
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Yes! And though I don't intend to use our Roths as such, they are a great catastrophic emergency savings since you can take out your contributions penalty-free. I don't think you can do that with a Roth 401k, though I'm not totally certain the rules on that.
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