It’s been a while since my last post – I’ve not made any stock purchases and I’ve been busy trying to figure out the effect of compounded dividend growth when the dividends are re-invested. It seems I was correct in my previous article comparing yield vs. growth that the mathematics behind it is complicated. I’ve been learning a lot but I’m not quite there yet.
Anyway in lieu of stock research, what I did recently was to revisit my Roth IRA and make some decisions about it. Currently this year I’ve not contributed to my Roth IRA.
I actually only learned about the Roth IRA about 3 years ago, or about 10 years after I first moved to the US. While 401(k) plans are probably the most popular retirement plan in the US, if you want to put more money aside for retirement you can additionally contribute to a Traditional IRA or a Roth IRA. You can invest in either or both, however the combined contributions can’t exceed the yearly limit or there are penalties. The yearly limit is $5,500 for 2014 for single head of household and you can find more information at the IRS.
The Traditional IRA
You can pay pre-tax or post-tax money into a Traditional IRA. If you participate in a company retirement plan e.g. a 401(k) as I do, then there are income restrictions for pre-tax contributions. If you’re single like me and earn more than $70,000 you can’t deduct any contributions from your taxes. Post-tax contributions however have no income limit; you can invest $5,500 (single head of household) regardless of your income.
You pay no taxes on the capital growth / dividend payments on investments inside the Traditional IRA account until you start to make withdrawals. Once you make a withdrawal however, the amount you withdraw is added to your taxable income and taxed as if it’s regular income. So even if you withdraw only dividend payments (which are normally taxed at lower tax rates); they would be taxed as ordinary income. In addition, once you’re over 70 years, you’re required to withdraw a certain percentage from the account each year or face penalties. This is known as RMD or required minimum distribution.
So for my situation, I can only pay post-tax money into a Traditional IRA account due to my current income level; and while the growth is tax-free, there’s potentially a higher tax on the withdrawals.
The Roth IRA
The Roth IRA was created in 1997 and named after its chief sponsor, Senator William Roth of Delaware. Only post-tax contributions can be made, and it’s subject to an income limit that reduces the maximum contribution amount in a scale starting at $114,000 to $129,000 (for single, head of household). So if you earn $129,000 or more a year then you can’t contribute to a Roth IRA at all.
As far as withdrawals, the Roth IRA is much more forgiving than its cousin; once you’re 59.5 years old, you can withdraw money tax-free, including any growth or dividends. If you’re younger than 59.5 you can also withdraw your contributions (but not earnings) penalty-free.
In my case, since I expect to be working until I’m at least 60 (based on my current projections), the Roth IRA is a pretty good deal. Except that the income restrictions prevent me from contributing the full amount.
Enter the ‘Backdoor’ Roth IRA
It’s possible to convert a Traditional IRA to a Roth IRA, however in 2010 the law was changed to remove income limits for such a transfer. The new law means that anyone can contribute $5,500 (post-tax) to a Traditional IRA since there are no income limits. You can then transfer the assets in the Traditional IRA to a Roth IRA, effectively contributing $5,500 to a Roth IRA, because there are no longer any income limits for that transfer.
There’s an important caveat here: This works only if all of your Traditional IRA accounts hold post-tax or non-deductible contributions. If your Traditional IRA accounts have any pre-tax or deductible contributions, then you’ll be required to pay taxes during the conversion. So please check with a tax professional if you have any questions about your personal situation.
In my case, I have only one Traditional IRA account which is held at Vanguard. It currently has $0 in it. I plan to contribute $5,500 post-tax into a non-growth investment such as a money-market fund, wait a month or so and then transfer the money-market fund from my Traditional IRA to my Roth IRA. My Traditional IRA goes back to $0 and I can then exchange the money-market fund in my Roth IRA for something else.
The reason for buying the money-market fund is that you will need to pay taxes on any earnings in the Traditional IRA when it’s converted to the Roth IRA. A money market account won’t earn very much in that time period.
Is this loophole legal?
Well the new law was designed specifically to encourage high net-worth individuals to exchange into a Roth IRA. The catch being that most people doing this transfer would have pre-tax money in their Traditional IRA and would end up paying taxes now. So in a sense, removing the limits was a way for the Government to get current tax income from Traditional IRA holders now.
I personally don’t believe there’s any legal issue here, but if you’re interested in reading some background on both sides of argument then take a look at the following article which asks “Will the IRS disallow backdoor Roth contributions?”
Again, please check with a tax advisor if you have any doubts.
Is the Roth IRA worth it?
This is really asking the question “Do you want to pay taxes now or later?” Generally speaking the Roth IRA has its biggest impact for young people who are starting their careers since they’re typically in a lower tax bracket. So after any free money from a 401(k) it makes sense to pay the lower taxes and invest in a Roth IRA.
I don’t think there’s a huge financial gain in my situation considering that I’m late to the party but it will give me more flexibility in retirement planning. The benefits as I see them are
- Flexible withdrawal options
- No taxes
- Good choice of investment options
- Loss of investment capital in taxable for current income
What should you put in the Roth IRA?
This obviously depends on your overall retirement strategy and individual situation. The principles of tax efficient placement is a great article to read for more background.
In my case I currently have the Vanguard REIT Index Fund (VGSLX) in my Roth IRA. Its high dividend payments are usually taxed as ordinary income so the Roth IRA is a way to limit taxes on that.
So I’ve convinced myself to contribute to my Roth IRA again this year. I have some money set aside from my house sale that I can use without affecting my dividend investing this year. While the Roth IRA won’t have significant impact on my future income, it’ll reduce my current taxes a little and I don’t really lose anything.
Quote of the day
The only difference between death and taxes is that death doesn’t get worse every time Congress meets.