roth ira Archives - Bankers Anonymous

August 14, 2024August 14, 2024

Averting College Financial Disaster – Barely

My family dodged a major financial catastrophe this Spring.

I have one large point to make about the difficulty of making optimal personal finance choices within one’s own family. In the telling of the story, I slip in some small points about paying for college and updates to 529 education savings accounts.

This story ends well, but for a while it looked like we were totally cooked, financially.

Pursuing one’s dream

In November 2021 we did an official campus tour of highly selective out-of-state private University A. Old buildings, beautiful weather. Incredible foliage. Everything you’d want based on the brochures. My daughter, early in her high school career then, fell in love. I think it was the foliage. University A became her top choice from then on.

You might think allowing her first to fall in love with, and then second to apply to, a private out-of-state university was the original sin we committed. You wouldn’t be wrong. On the other hand, she has told us for at least the past four years that going to college out of state was a primary criterion. We respected that. Also in our defense we had not been totally irresponsible with funding her 529 account, which we started when she was 1.5 years old. The account had grown to something substantial.

Unfortunately, the sticker price of higher education for private universities has also grown, but to absurd heights, over the last 20 years. What normal family can afford this? If you haven’t checked lately, the all-in cost (tuition, room & board, books, fees, insurance and transportation) is about $90 thousand per year. Multiplying that by 4 years gets you to $360 thousand for an undergraduate degree. What even? Huh?

Briefly about 529 Accounts

529 accounts are merely fine investment vehicles. They are better than nothing. They are inferior to retirement accounts like 401Ks or IRAs.

I advise parents who have to choose which bucket to place their scarce investment dollars to fund their own retirement accounts more generously than their child’s 529 account. The tax advantages, opportunity for employer-matching, and long-term growth are all superior in retirement accounts as compared to a 529 account.

Another long-time knock on – or at least fear about – 529 accounts was that overfunding these accounts could leave dollars stranded, unusable for education purposes. I know that’s possible because two different families I am close to – relatives of mine – have overfunded their kids’ 529 accounts.

A 2024 change in 529 rules has made these accounts somewhat better and reduced the risk of “stranded money.” I’ll describe the rule change below.

But first, back to my daughter’s college journey.

She received a number of college acceptances this Spring, including her dream school, University A. Yay!

Because of its prestige, it has a policy of not offering merit scholarships. This is typical of highly selective universities in which the admission office essentially says “all of our accepted students have extraordinary merit,” so nobody gets money on that basis. Boo!

University B – With a generous merit scholarship!

She also got into University B with a very generous merit scholarship. For social and sporting reasons she also strongly considered University C, which offered a decent scholarship. In April of this year she had narrowed down her choice to A, B, or C. All three out of state, and private. The sticker prices for each is wildly high, but because of the three different merit scholarships, A, B, and C had totally different actual costs for our family.

The difference between finance rules and real life

With my finance-guy hat on, I know the cost of private out of state college is utterly ridiculous. Unconscionable. Absurd. Specifically, University A would cost us more than twice the amount that we had saved up over 17 years.

University C was also in the mix as an attractive option

But I am not only a finance guy. I am also a dad and a husband. And something strange happens when you try to apply finance-guy rules to real life choices for people who you love more than anything in the world. The rules melt away in the face of your most precious relationships.

[A reader recently wrote in to chastise me for making certain choices with respect to home equity line of credit debt, which isn’t in line with theoretical best practices. That’s right, I have done that. I will continue to deviate from best practices at times. Other criteria are sometimes preferable to the finance theory.

I know deep in my bones the personal finance rule that for a student – and her parents – going into extraordinary debt for undergraduate education is not a wise idea. And yet, when it came to the moment for my daughter to decide on college before May 1st, 2024, we did not insist on her choosing the optimal financial strategy.

We said she could choose University A.

My wife and I were those parents who did not enforce the right thing financially. Because of the crazy cost of private higher education, we faced taking on six-figure debt to make her dream come true. To paint a slightly fuller picture of the University A scenario, we also would have required our daughter to borrow the full amount of Federal unsubsidized loans under her own name, which adds up to $27,000 over four years. Which is also not optimal.

Financially, this was nuts. Emotionally, however, we were not willing to deny her a chance to pursue her dream.

The new 529 to Roth IRA rules

As I promised, I also have a small point to make about paying for education. That is, while 529 accounts aren’t amazing, they just got incrementally more flexible in 2024. That’s a good thing. Beginning in 2024, surplus funds – by which I mean money in a 529 account that will not ultimately be spent on the beneficiary’s education – can now be repurposed in a very advantageous way.

Surplus 529 account funds can be contributed to a beneficiary’s Roth IRA, with certain restrictions in the fine print, as follows.

First, the 529 account must have been open for a minimum of 15 years. Next, the lifetime limit for moving surplus 529 funds to a Roth IRA is $35,000. At the current annual individual contribution limit of $7,000, it would take at least 5 years to max out this 529 to Roth IRA conversion opportunity. In addition, the IRA beneficiary must have earned at least the contributed amount of income in the year it was contributed. So for example, a student earning $3,000 in income during a calendar year could only contribute up to $3,000 to her IRA that year. Finally, funds in the 529 have to have been in the account for more than 5 years before turning them over to the beneficiary’s Roth IRA.

These are a lot of conditions to satisfy. The purpose of all these persnickety rules is to make sure the 529 account is not being used as a backdoor Roth IRA funding loophole.

This 529 to Roth IRA rule is available this year for the first time in 2024.

Which is very very good! Because we got lucky and our daughter decided to give up her dream of University A in favor of University B. With University B, because of their generous merit scholarship, we will have funds left over in her 529 account at the end of 4 years.

In my family’s particular case, we satisfy all the persnickety conditions, so we are eligible to help fund our daughter’s Roth IRA, up to $35 thousand dollars, in her early working years.

This is all subject to change if she chooses instead to go to graduate school or some other educational opportunity that is more attractive than funding her Roth IRA. She starts University B in a few weeks. Hopefully she’ll have a Roth IRA funded after her first 5 working years as well. We got lucky and it was a very close thing.

A version of this post ran in the San Antonio Express News and Houston Chronicle

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October 28, 2019November 20, 2019

FIRE Part I – Taxonomy of Early Retirement

Up until now I’ve mostly ignored the Millennial FIRE movement, which stands for Financial Independence, Retire Early.

My buddy Justin S. introduced me to some retirement planning strategies I’d never heard of recently, strategies that he is considering using in the next few years as part of his FIRE plan. FIRE is the aspiration of many 20 and 30-somethings, who hope to quit their jobs by age 40 or so. It would be easy – as with all trends involving Millennials – to exaggerate and strawman-ify the FIRE movement.

Justin, a software engineer at a large financial services company in San Antonio, is 39 years young. He hopes to be able to retire within the next five years.

Justin’s FIRE journey began 1.5 years ago when he and his wife began to really examine what role paid work should, and should not, play in their lives. It was at that point that they got serious about trying to accumulate savings enough to let them walk away from work within ten years.

He says his wife had always been a natural saver, whereas he had enjoyed buying nice cars and a motorcycle. In an earlier phase of life he’d bought a condo at the worst time and place (Central Florida, 2007), an experience that left him with wrecked credit and a searing fear of being stuck financially, living paycheck-to-paycheck.

Says Justin, “My primary driver is to not be in a position like that again. Anything can happen at work, anything can happen with houses.”

He’s gotten deep into FIRE-oriented blogs, retirement strategies, and tracks his progress on a free website.

with numerous retirement calculators. His ultimate goal is to have enough saved that he could choose more hands-on work. He seeks something more tangible than software, something that would give him a more tangible sense of accomplishment.

Justin explained to me the many variations on FIRE. To save you some time navigating Reddit threads, finance blogs and YouTube channels, here’s your guide to different FIRE flavors.

Lean FIRE – This is Justin’s plan. This means figuring out the bare minimum income you need to survive on annually, usually by making choices to downsize a home and car, location, and lifestyle. If Justin and his wife can figure out a way to live on $35,000 per year total, for example, and assume a 5% annual withdrawal rate, then theoretically they would only need $700,000 in a nest egg to call it quits in five years. (These are my numbers, not theirs, and just reflects a starting point for planning)

Obviously they (or we) can tweak some assumption about tax rates, rates of return, inflation, and their ability to eat only rice and beans forever, but you can sort of see the initial plan start to come together.

Inherent in Justin’s Lean FIRE planning, he says, is a commitment to live cheaply enough that work isn’t necessary. If that means living in a lower-cost state, or even a lower-cost country, he’s ok with that. Their reward will be freedom from having to work in an office or depend on a paycheck in the future.

Fat FIRE – This is for folks who make a high enough income that they can build a hefty nest egg for later. Generally this also means sacrificing current wants to ensure future luxury. Or as Justin says, Fat FIRE adherents want to live middle class today in order to live upper class in the future. Of course, part of the goal is to build that nest egg as quickly as possible in order to still retire early. A Fat FIRE pile of savings is by definition far higher than a lean FIRE pile of savings.

Barista FIRE – This is for current corporate drones who dream of giving up a career advancement and responsibility and who have seek to have enough money in the bank to just work a minimum wage job with good benefits. Since healthcare costs naturally represent a major barrier to early retirement, the “Barista FIRE” enthusiast may sign up to work for a company like Starbucks, post-retirement, for the generous benefits rather than for the paycheck. FIRE in this case doesn’t mean a full retirement but rather the independence from work that requires long-term responsibility, career, and those jerks from headquarters requesting you come in to finish those TPS reports on Saturdays.

Coast FIRE – This is for folks who have made their “number” for financial independence but don’t actually have an incentive to quit yet. Maybe their spouse isn’t ready to retire early, so it’s worth hanging on to a job. But they can ‘coast’ for a while without the pressure to actually work to pay one’s bills.

All in all, of course, you can criticize and exaggerate these different versions of financial independence and retiring early. Assumptions may strike us as unrealistic. The goal may seem overly materialistic, or not materialistic enough. Personally, my main objection to seeking to retire early is that work is what gives us meaning. If we don’t like work and seek an early retirement, maybe the solution is to seek different work that better suits our skills and interests?

Older barista may be totally financially secure, just doing it for the healthcare.

And yet, every responsible financial planner would ask her client to set forth a future plan, make realistic assumptions about savings and investment to get there, and then ask what the client is willing to give up to make the future a reality. That’s what the FIRE adherents are doing. Financial independence always requires some version of these steps, even if some FIRE enthusiasts take it to the extreme.

At the extreme, of course, even the financial independence aspect of FIRE can be overdone. Just as body dysmorphia pushes even the thinnest people to cut calories, so can the FIRE movement lead to penny-pinching absurdity. Justin is not in that problematic category, but you don’t have to look hard online to see people maximizing their savings to an extreme that doesn’t make a ton of sense.

What about those specific FIRE retirement account strategies Justin mentioned that I hadn’t heard of before? I looked into them. They aren’t exactly universally recommended – nor is FIRE for that matter – but I’ll describe them in more detail in an upcoming column.

Please see related posts:

FIRE Part II – Some Complex Techniques

FIRE Part III – On the Benefits of Frugality

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August 15, 2019August 15, 2019

Improving Retirement, Reducing Aristocracy

I’m a fan of tax-advantaged retirement accounts, like IRAs and 401(k)s. I’m also a fan of reasonable federal legislation to periodically update these accounts to make them attractive, available, and useful as retirement savings tools, while still serving society’s best interests.

The Democratic-controlled House passed The Setting Every Community Up For Retirement Enhancement and Savings (SECURE) Act in May 2019. It’s a bi-partisan bill, with the Republican Senate expected to approve it sometime this year, possibly with minor modifications. The Republican President is expected to sign it into law. It’s almost as if we have a real functioning government and cooperation on an important issue, people! This is exciting!

The SECURE Act provides a bunch of incremental improvements to retirement fund rules and most of the changes are investor-friendly – in the sense that they make IRA rules more generous and more advantageous for investing in one’s retirement.

I’ll list below some of the small, but good, improvements for investors below, but after that I want to highlight the only part of the proposed bill that is actually less generous to investors. The fact that it is less generous is good, in my opinion, although many of you savers and investors might disagree with me.

Incremental Improvements

But first, I’ll highlight the goodies for investors, if and when the bill passes.

You can make contributions up until any age into a Traditional IRA, rather than having to cease contributions at age 70.5.
The age for starting Required Minimum Distributions (RMDs) would increase from 70.5 to 72.
Small businesses could form multi-company groups to offer 401(k) plans, to share and therefore reduce administrative costs.
Part-time workers could participate in 401(k) plans

These are all incremental but each increases incentives to save and invest over the long run in a tax advantaged way.

There are a few other proposed provisions – some regarding 529 accounts and others requiring disclosure on 401(k) plans about how much income could be derived from account balances if annuitized.

One of the proposals in the SECURE Act limits something called the ‘stretch IRA.’ I like the stretch IRA personally, but hate it philosophically – so limiting it strikes me in opposite ways.

On the personal side, if there’s a way to reduce taxes and build wealth, I may want to do it myself and I usually tend to tell other people about it. This is a case of: It shouldn’t exist, but since it does exist you should take advantage of it if you can. I’ve previously written about the joys and opportunities of the stretch IRA in my book on personal finance and on my blog.

On the philosophical side, however, the stretch IRA rubs me the wrong way. I mean that from a “societal good” perspective. The principle of the thing, like much of tax reform around inheritance over the last thirty-five years, tends to aggravate one of our great societal problems already: wealth inequality.

Here are the basics of a stretch IRA, which the SECURE Act, as currently passed by the House, limits.

The image that comes to mind with Trust Fund kids

Heirs who inherit an IRA are required to withdraw a certain amount money every year based on their own expected lifetime. They have to take out an amount calculated as the account value divided by their expected remaining life (as determined by an IRS table.) An 18 year-old, with an expected remaining life of 65 years, for example, who inherits $100,000 from Grandma’s IRA, would be required to withdraw around 1.5% of her account as income this year. Or $1,538 – because that’s $100,000 divided by 65.

Importantly for the ‘stretch’ theory, however, she could leave the remaining amount in the account to grow, tax-advantaged, into the future. Each year, the heiress would only be forced to withdraw a small amount. Based on her long remaining life and small withdrawals, her inherited stretch IRA account, under most scenarios, would grow until approximately her own retirement age. Carefully done, that’s nearly 5 decades of tax-advantaged inheritance, a growing account, and a rising annual income from the account.

I say, old chap, that sound delightfully like the good old days of the English aristocracy.

With careful planning, this could produce millions of tax-advantaged income over the young heiresses lifetime. The larger the original inheritance, obviously, the larger the advantage. The traditional key to a stretch IRA is to leave funds to young heirs, who can take advantage of the rules of required minimum distributions, based on a long ‘expected life.’

The limit proposed by the House version of the SECURE Act is that inherited IRAs would have to be fully withdrawn within 10 years, curtailing the ‘stretch’ previously enjoyed by young heirs.

Fighting the Aristocracy

So what’s my big problem with the “stretch IRA?”

Simply this: Children don’t deserve free money. Intergenerational wealth transfers merit careful limits. My particular American preference for a democratic world makes me think aristocratic societies – in which inherited wealth creates lifetime comfort for a fortunate few – are bad. The stretch IRA was one small piece of a larger intergenerational wealth-transfer industry. So I applaud the SECURE Act’s attack on it, or for limiting it to just 10 years, on these philosophical grounds.

Finally – were I a betting man about this part of the SECURE Act, I’d bet against the right thing happening. I am a complete Washington outsider, but I do have a cynic’s instinct for who funds Congressional campaigns. There’s a particularly high correlation – regardless of party – between people who fund Congressional campaigns and people who understand and can benefit from tax-advantaged intergenerational wealth transfers.

The history of tax and estate legislation regarding wealth transfers for the last 35 years – regardless of the party in Congress – appears to me an unrelenting move toward favoring the establishment of intergenerational wealth. So, I personally wouldn’t bet on this small step against the American aristocracy surviving in the Senate this year.

But, we can hope. So far, it’s still in the bill.

Please see related posts:

The Magical Roth IRA

So I guess we all like Trust Fund Kids, right?

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March 30, 2015April 1, 2015

Ask An Ex-Banker: The Magical Roth IRA

A version of this post ran in the San Antonio Express News.

Dear Michael,

Next January, when I receive the proceeds for a house I’m selling, I’m considering converting 70K from my TIAAF-CREF Traditional IRA into a Roth IRA, and paying taxes to do that that. I could then make my 7 grandchildren the beneficiaries and plan to not spend any of the Roth IRA myself unless I was desperate. I am 72 years old now, and my seven grandchildren range in age from 4 to 18. Could you make a spreadsheet to show me – and them – how nice that would be for them if I died at 90 and they received tax free income until they are all age 72 themselves?

Thanks,
Julie from Massachusetts

Dear Julie,

Thanks for your question. You’ve highlighted one of the cool and little-discussed features of the Roth IRA, a potentially magical low-cost estate-planning tool for passing on tax-free income to young heirs.

The Roth IRA magic I’m about to describe happens because of three features unique to Roth IRAs.

First – unlike a traditional IRA – all withdrawals from an inherited Roth IRA are tax free to the beneficiary. Roth IRAs, we recall, require income taxes to be paid up front, either when a contribution is made, or in the case of Julie, when an existing Traditional IRA converts to a Roth IRA.

Second – also unlike a traditional IRA – you are not required to make any withdrawals from your Roth IRA in your own lifetime. If you can manage to survive without pulling out money from your Roth – as Julie referenced in her question – then you can leave that much more money for your heirs.

Third – heirs can withdraw money slowly enough from their inherited Roth IRA that their little nest egg can actually grow over time. The IRS has a schedule for inherited IRAs that shows how to calculate just how slowly money may be withdrawn.

By exactly how much money will the grandchildren benefit, and how does it all work?

tax_free_inheritance — Tax Free Inheritance!

The total value

I’ll take Julie’s example and run through the numbers, but let me hit you with the punch-line first:

Julie’s nest egg would produce nearly $1.2 million of tax free income for her grandchildren.

Here’s some fine print on that punchline: $1.2 Million of tax-free income assumes Julie starts with $70,000 next year; She dies at age 90; all of her grandchildren take only their minimum distributions until they turn 72; the accounts earn 6% per year; and each grandchild receives the total remaining value of their inherited Roth IRAs at age 72.

If I keep all of those above assumptions, except I dial down the annual return to a more conservative 3% return per year, her grandchildren receive $273,054 in total tax free income.

But what about the following?
If I dial up the annual return to a more optimistic 10% per year, her grandchildren would receive a total of $9.2 million in tax free income. ¹

Now that I have your attention, how does the Roth IRA achieve this magic trick?

The magic happens over two phases, Julie’s life, and her grandchildren’s lives.

Julie’s Life

Traditional IRAs ² require an owner to withdraw a portion of their retirement account as income every year after age 70.5. The IRS publishes a list for IRA owners age 70.5 and older about their required minimum distribution, roughly determined by the retiree’s expected remaining lifespan.

According to the IRS, A 72-year old like Julie would be required to divide the value of her IRA by 25.6 (the same divisor goes for all 72 year-olds), and take at least that amount out of her traditional IRA as income. ³

With a $70,000 Traditional IRA, Julie must withdraw at least $2,734.38 at age 72, (because that’s $70,000 divided by 25.6).
With a $70,000 Roth IRA, however, she is not required to withdraw anything.

If Julie is able to survive on rice and beans (and Social Security, and other savings) without drawing from her Roth IRA, the account will certainly grow for the next 18 years. At a 6% annual growth rate, her Roth IRA would reach $188,494 when she reaches age 90. At which point we assume each of 7 grandchildren inherits a Roth IRA worth $26,928 (because that’s $188,494 divided 7 ways).

The grandchildren’s lives

An inherited Roth IRA requires an heir to make minimum withdrawals, but in small amounts determined by the age of the heir. The minimum withdrawal amount is determined by the value of the Roth IRA divided by the expected lifespan of the heir.

The key here to the Roth IRA magic is that Julie’s grandchildren are relatively young, and the IRS allows young people with a long expected lifespan to withdraw money from inherited IRAs quite slowly.

So slowly, in fact, that each grandchild’s account is likely to grow over time, under reasonable annual return assumptions.

The eldest grandchild
Julie’s eldest grandchild, now age 18, would be aged 36 when Julie is 90. The grandchild could elect to take the inherited $26,928 all at once, but would be advised not to do so.

Instead, she should allow the account to grow over time, kicking off a growing amount of tax free income per year over the course of her lifetime.

At age 36, the eldest grandchild has an expected remaining life of 47.5 years, so could elect to take the minimum of tax free income of $555 (because that’s $26,928 divided by 47.5).

With that minimum withdrawal, assuming a 6% return, the account will grow each year. Withdrawals will increase each year as well, up to $4,136 when she is 72 years old, when the account will be worth $67,424.

The youngest grandchild
For the youngest grandchild, the deal is even sweeter. She would inherit $26,928 at age 23. Her original minimum withdrawal of tax free income would be $448 (that’s $26,928 divided by her expected remaining lifespan of 60.1 years). Minimum withdrawals would grow up to as much as $7,090 by age 72, at which point the account would be worth $109,903.

The younger the heir, the higher the potential for maximizing this Roth IRA magic, which can produce tax free income for life, long after the original retiree has passed.

In the most optimistic scenario, if markets return over the next 100 years at the rate they have in the past 100 years (a key “if”) Julie’s conversion of her relatively modest $70K Traditional IRA into a Roth IRA would produce close to $10 million in future tax free income for her grandchildren.

Please see related posts:

The Magical Roth IRA

Estate Tax – My Problems With It

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Incidentally, even though past performance is not indicative of future results, the S&P500 (including reinvestment of dividends) has earned 11.7% over the past 40 years. ↩
Just like other retirement accounts such as 401Ks and 403bs ↩
As a retiree ages and her remaining lifetime shortens, the IRS requires the retiree to divide by a smaller number, leading to higher distributions. A 90 year old must divide her traditional IRA account value by 11.4 for example, so would have to take out a minimum of $6,140 on a $70,000 account (because that’s $70,000 divided by 11.4). ↩

December 12, 2013January 26, 2015

Ask an Ex-Banker: Should I open an IRA?

Planting_Money — This picture comes up when you type ‘ira investing sexy’ into Google Docs. Just FYI.

Dear Banker,

I’m ready to purchase IRAs for my husband and me. We had fun as young 20-somethings and didn’t start saving anything for retirement until our 30s, and even then, sometimes one of us was not always able to set aside money into the 401K/403b offered by employers. So, I figured an IRA would be a good option to help set aside additional funds for retirement. We already have life insurance squared away and are debt-free, apart from our mortgage, and have emergency funds set aside for miscellaneous emergencies (I’m a planner!). I’d rather be taxed now, so I know a Roth IRA would meet that requirement, but what else should I look for? I’m interested in opening the accounts with $2,000 each since I understand we won’t be held to a minimum monthly deposit towards the account that way.

Thanks for any suggestions you might have!

Jessica in San Antonio, TX

Dear Jessica,

I’ll answer some of your questions quickly, and then go back and fill in the details to the same questions below.

Should you do it?

Yes

When should you do it?

Yesterday

Roth IRA vs. Traditional IRA?

Doesn’t matter

How much should I invest?

$2,000 each for you and your spouse is great.

For 2013 and 2014 the maximum amount per person is $5,500

What to invest in?

A low-cost, diversified, equities-only, mutual fund.

With whom should I open the account?

Well, since none of the fund companies are paying me through advertising, I’m reluctant to name…Ok, fine: Vanguard.

Since you may want more details with each of these topics, I flesh out my answers below.

IRA_Not_Dead_Not_Poor — Sorta funny, sorta true

Should you do it?

Yes.

If you have any surplus money available for savings and investment – in your case, $4,000 this year – open your IRAs before doing almost any other savings or investment activity.

Because IRAs offer-tax advantaged investing, it’s virtually impossible to beat the returns in an IRA account when compared to any other investment account.

Why do I say that? There are several reasons, all having to do with ‘after-tax’ calculations.

Tax advantages in the year you contribute to an IRA

If your income tax rate is, for example, 25%, then you need to earn $2,500 in order to have the equivalent of $2,000 available to invest in an account.

For non-IRA investing, right off the bat, $500 goes to the IRS, and $2,000 goes in your bank.

When you invest in a traditional IRA, however, the full contribution amount can be deducted from your taxable income. The result – at a 25% tax rate – is that you have 25% more money to invest.

Another way of saying this is that you got a 25% ‘return’ on your after-tax investment just by putting money into a traditional IRA when compared to investing through a non-IRA account.

Does this matter in the long run? Yes!

Here are some calculations, using the magical powers of compound interest math, to illustrate the long-term difference in outcomes between IRA investing and non-IRA[1] investing.

Invest $2,500 in 2013 in an IRA for 30 years and earn 5% per year. Result: $10,805.
Invest $2,000 in 2013 in a non-IRA for 30 years and earn 5% per year. Result $8,644.

Tax_advantaged_investing_grows_over_time — $500 tax advantage grows to $2,000 in 30 years at 5% return

That’s more than a $2,000 differential in the end, an amount higher than your initial contribution amount. The greater the return assumption over the 30 years, the higher the final difference between IRA and non-IRA accounts.

If you invest this way, every year for 30 years, always choosing the $2,500 tax-advantaged IRA contribution rather than the $2,000 after-tax contribution, earning 5% per year on each contribution, you will have $174,402 rather than $139,522, a difference of $34,880.

Tax advantages of transactions inside your account

The tax advantages of IRAs do not stop there.

Or as the late-night television Ginsu Knife Advertisement would say: But Wait! There’s Much, Much, More!

Any time you sell a stock or mutual fund position in a traditional (non-IRA) investment account you must pay taxes that year on any appreciation (or gains) in the investment. If you held the stock for less than a year you will owe your regular income tax rate of 25% on the money you made.

Ginsu_Knife_Now_How_much_would_you_pay — IRAs, like Ginsu knives: But Wait! There’s More!

Even if you held the stock for more than a year you would owe long-term capital gains, probably 15% in your case. If you receive dividends or bond payments within your investment account, those will also be taxed at high rates such as 25%. Giving back 15-25% of your investment gains when the stock went up is incredibly destructive to your future wealth-building plan.

For this reason, actively buying and selling stocks in a traditional investment account makes about as much financial sense as stabbing your money with a Ginsu Knife.[2]

If you sell a stock or mutual fund within your IRA, by contrast, you owe no taxes on the gains. This, as the financially-savvy Seattle-based poet Macklemore would say, is f-ing awesome.

If you plan to sell any investments in your account over the next 30 years, you will do yourself a huge favor if those investments remain shielded from taxation within an IRA.

Macklemore_thrift_shop — This poet knows thrift like Bo knows baseball

Tax advantages of retirement income from the Roth IRA

I see from your question, Jessica, that you’re oriented toward a Roth IRA rather than a traditional IRA. If you open up a Roth instead of a traditional IRA – and I don’t blame you if you do – you do not reap the income tax benefits in the year you invested. You would instead enjoy tax-free income in your retirement years when you take the money out, which is also quite awesome.

roth_ira_money — Roth IRA or Traditional IRA? Both are great!

The most important financial comparison is not between a traditional IRA and a Roth IRA, but rather between a non-IRA and an IRA account

In your retirement years, when you sell your investments for income, a Roth IRA is more valuable than a non-IRA account because of the difference in after-tax income.

If you have a 25% income tax bracket in your retirement years, for example, your $10,000 in Roth IRA income is the equivalent of $12,500 in non-IRA income.

Ok, time to move on to the next answer to your questions.

When should you do it?

Yesterday.

I answer “yesterday” in a nod to the old investing saw “When is the best time to invest?” for which the correct answer is always “thirty years ago.”

The most important factor for racking up impressive investment returns is the passage of time. Due, as always, to the magic of compound interest.

The good news, however, is that if you open your IRA now, in your 40s, you actually can take advantage of the next thirty years. By the time you and your husband retire and need to live off your investments, you will have invested “thirty years ago.” You will enjoy Madame President Cyrus’ administration in 2043 that much more if you feel wealthy.

Madame_President_Cyrus_in_2043 — Madame President Cyrus in 2043, when your IRA has grown for thirty years

So go for it. Today.

Roth IRA vs. Traditional IRA

Doesn’t matter.

Much digital ink has been spilled parsing the advantages of one vs. the other. But do we really have to argue?

Beatles vs. Rolling Stones.[3]

Brady vs. Manning.[4]

Kristen Bell vs. Jennifer Lawrence.[5]

These are all awesome choices.

Kristen_Bell_Jennifer_Lawrence — Kristen Bell or Jennifer Lawrence? Do not make me choose

Both the Traditional IRA and Roth IRA beat any non-IRA option available.

Confidently choosing one over the other would require you to compare today’s income tax rates to future income tax rates in your retirement, something you can guess at, but with no certainty.

Roth IRAs boast a clever feature that allows you to pass on wealth to young heirs which I wrote about before, but income eligibility limits make taking advantage of the Roth IRA harder than a traditional IRA.[6]

How much should I invest?

Your planned $2,000 each for you and your husband is great to start. The more the merrier.

Again, a $5,500 upper limit for you if you’re under age 50. A $6,500 upper limit if you’re aged 50 or older.

The income limits for IRA contributions are maddeningly complex for such a simple investment vehicle, a point which I tried to make last year (probably unsuccessfully) through this purposefully confusing infographic. For your purposes, however, the $2,000 is a great place to start, and I agree you’ll avoid charges from most investment companies with a $2,000 minimum.

A quick aside on the subject of minimum investments:

I taught a personal finance course to college students last Spring, and one of my mandatory assignments for these 18-22 year olds was to open their own IRA. I figured that even if they only had $100, and even if that $100 went into the wrong product, the practical and pedagogical benefit of opening the account and researching the account would more than make up for the inefficiency, cost, and their lack of any actual income that required tax-deferral. My theory was perfectly sound. Just ask me.

In practice, the assignment really pissed them off. They didn’t have $100 extra (so they claimed), and they quickly discovered very limited options for their minimal investment amounts (a bank CD for example), and fees on top of that, if their balance remained below something like $1,000 or $2,000. I endured a few weeks of complaints and hissing with steely resolve until my co-teacher intervened and made the assignment optional. Probably saved my tires from being slashed.

The lesson: I’m a real pain in the ass as a teacher.

Also, IRAs don’t make sense for less than an initial $1,000 to $2,000.

What to invest in?

Jessica, I want to make your life easy. Trust me on this next one.

An entire Trillion dollar industry – known around these parts as the Financial Infotainment Industrial Complex – would like you to pay extraordinary, mostly obscured, fees for a very ordinary financial service.

The industry would also like you to believe that an entire universe of options must be sifted through, parsed professionally, opined upon, and cleverly navigated. You don’t have time for that. You don’t need that.

What you want with your 30-year time horizon until retirement is the chance to receive the returns of broad equity markets. Not beat the market, just get the market returns.

So, your goal is:

1. Pay minimal fees

2. Earn the market return

3. With a 30-year horizon, you need 100% equities. You cannot afford the low returns of anything less risky.[7]

The words you need to know are: “a low-cost (probably indexed) mutual fund covering a broad sector of either US or global equities”[8]

Keep asking for that, and only that, until you get it.

Choose_Index_fund_every_time — One illustration of index versus managed funds

With whom should I open the account?

Vanguard doesn’t pay me to say this (which sucks for me)[9] but they pioneered this type of investing decades ago, and so they deserve credit for doing the right thing, early on. My own retirement account is with them.

At this point, dozens of other mutual fund companies offer a similarly awesome “low-cost (probably indexed) mutual fund covering a broad sector of either US or global equities.”

If you or a friend or family member already has an account or a relationship with any of these other fine companies, by all means open up an account with that other company. I believe in signing up for the fewest number of service providers.

But do not let them talk you into anything more complex (read: expensive and unnecessary) than what I described in quotes above.

Jessica, I hope that helps, and congrats on getting going with your IRAs.

Please see related posts on the IRA:

The Humble IRA

IRAs don’t matter to high income people

A rebuttal: The curious case of Mitt Romney

The magical Roth IRA and inter-generational wealth transfer

The 2012 IRA Contribution Infographic

The DIY Movement and the IRA

Angel Investing and the IRA

[1] By “Non-IRA” I just mean any old investment account that you might buy stocks in. A regular taxable account. Something not tax-advantaged like an IRA or 401K plan.

[2] After which, of course, the knife will remain sharp and cut easily through a ripe tomato.

[3] Beatles.

[4] Brady. Duh.

[5] Don’t make me choose, I don’t want to break either of their gentle hearts.

[6] Incidentally – and not relevant to your original question – if I had plenty of disposable wealth and income and a large traditional IRA, I’d probably convert it to a Roth IRA.

[7] As best explained in this book Simple Wealth, Inevitable Wealth by Nick Murray,

[8] Global is better than US, for a variety of theoretical reasons simply explained in this book I recently reviewed, but investing in a broadly diversified US equity index is also not ‘wrong’ for your purposes.

[9] Hey Vanguard? Throw me a freakin’ bone here!

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April 3, 2013May 12, 2020

The Magical Roth IRA

[EDITOR’S NOTE: Some of the magic of the stretch Roth IRA got eliminated by the 2017 tax reform. So this post, while popular, is less accurate than it was when I wrote it in 2013. Roth IRAs are still lovely, but the stretch properties aren’t available]

Less than two weeks left to fund your 2012 IRA, so I’m continuing my series on these maddeningly humble, but potentially interesting, retirement accounts.

But, to get caught up, please see earlier posts on The Humble IRA,

IRAs don’t matter to high income people and A rebuttal: The curious case of Mitt Romney

The Roth IRA boasts a few magical advantages over the traditional IRA, but the most interesting one has to do with intergenerational wealth transfer.

Being a grandparent with some wealth to pass on to worthy heirs involves a seeming Catch-22: How can we give our sweet, beautiful, grandchildren easy money but still help them avoid the hookers and cocaine?

I have no suggestions for you with respect to the latter problems, but the Roth IRA can really help with the wealth transfer part, in a simple, low-cost way.

What’s unique is that the Roth IRA’s super-simple, low-cost, inter-generational wealth transfer tool otherwise doesn’t exist for middle-income folks.[1]

How the Roth IRA differs from the Traditional IRA on mandatory minimum distributions

With a traditional IRA, a retiree must begin withdrawing funds after age 70.5, in proportion to her age. The formula for distributions, in fact, is calculated as Mandatory Distribution = Account Balance divided by Life Expectancy.

A 75 year-old retiree with $200,000 in a traditional IRA who has a 13.4 year life expectancy – according to IRS document 590 “Appendix C” in the hyperlinked document here [2] – must withdraw $14,925.37 this year, the result of dividing $200,000 by 13.4.

This is fine for people who need the money in retirement, although unfortunately withdrawals from the IRA account will be taxed as ordinary income.[3]

But for a retiree who does not need the money, and who would rather pass on as much money as possible to her heirs, the Roth IRA has a huge advantage over the traditional IRA because the Roth does not mandate any distributions during the retiree’s lifetime.

Thus, a Roth IRA can grow larger and for longer than a traditional IRA. If the retiree chooses, she can eschew distributions from Roth IRA altogether until the account passes to her young heir.

Why does this matter so much?

The magic trick of the Roth IRA is that, while annual distributions must begin immediately for heirs, a retiree may select a very young heir to inherit the Roth IRA, such as a grandchild or great-grandchild.

What that means is that annual ‘required distributions’ are very small, especially in the beginning, so that the account itself may become a kind of perpetual source of tax-free income for a child who inherits the Roth IRA.

Can I get an example please?

A concrete example helps illustrate the magic involved.

Our 75-year old retiree named a young beneficiary, say, 5 years old to inherit the Roth IRA with $200,000 in it.

I assume the deceased retiree’s total estate assets total less than the $5.25 million estate tax exemption, so her $200,000 Roth IRA passes estate-tax free to the child.

After the 5-year old child inherits the Roth IRA, minimum distributions must begin.

But the minimum distribution amount will be quite small, calculated again as the ratio of the account balance divided by expected life of the beneficiary. Since a 5 year-old has an expected life of 77.7 years – again, according to this IRS appendix – the minimum income distribution from the account is just $2,574, or $200,000 divided by 77.8.[4]

Now, $2,574 in income is a small, good, thing for a 5 year-old to have, but that’s not the real point of the magical Roth IRA. The real point is that the income will grow over time under ordinary compound interest conditions. Since compound interest is, as we know, the greatest power in the known universe, this acorn of a Roth IRA carries within itself oak tree potential.

Financial Sustainability!

You see, the key point is that the minimum distribution to a 5 year-old kid is just 1.29% of the principal. If the account can earn something close to a historical rate of return on long-term investments, let’s say 5%, then that Roth IRA grows significantly over time. The gift just keeps getting better as the child grows up, for the rest of her life.

As I wrote before, one of the hardest parts about financial sustainability is that the percentage allowable distribution – typically 4% or 5% – might just reduce principal in a low-return environment like we’ve experienced lately, and at least runs a high risk of diminished purchasing power.[5] This is a problem every foundation, school, hospital or individual retiree worries about right now, because distribution amounts are too high for the cumulative returns we’ve seen in the past decade, and the risk-free returns achievable now.

But the Roth IRA minimum distribution amount for young heirs, on the contrary, is utterly, awesomely, magically, sustainable. As a result, all throughout this period, the odds are very good that the Roth IRA will grow in value in the long run, assuming the account is invested in an ordinary market, earning ordinary returns per year.

The lucky Roth IRA heir

Let’s follow this lucky 5-year old heir through time, as a beneficiary of the original $200,000 Roth IRA.

At 25 years old, the heir to the Roth IRA has a 58.2 year expected remaining life, and still would have to withdraw only 1.72% of principal. After receiving tax free income distributions for 20 years,[6] assuming a 5% return on investments, the account is now worth $413,255 and the annual distribution has increased to $6,874.

When our beneficiary of the Roth IRA reaches 50 years old, with a 34.2 year expected remaining life, she may still withdraw only 2.92% of account principal. Her inherited Roth IRA has grown to $815,005, and the annual draw is now up to $23,345, again tax free.

Not until the young beneficiary lives past age 66 – with a life expectancy of 20.2 years, do the Roth IRA minimum distributions go above 5%, the traditional threshold for financial sustainability.

By the time she reaches her own retirement age of 65 years old, the account is worth just shy of $1 million – more precisely $978,629 by my calculations – all assuming the minimum required distribution and a pedestrian 5% return every year.

Under this scenario of a 5% market return and minimum distributions, the lucky Roth IRA heir has taken home $957,344 in income over 60 years, paid no income tax on that money, and now controls an account worth $978,629.

As that guy from Entourage would say, is that something you might be interested in?

Could it be larger? Absolutely

Just to dream a little bigger for a moment, what if the Roth IRA returns 7% per year over that period?

Why then, that lucky heir took home $2,274,512 in tax free income between ages 5 and 65, and at age 65 she controls an account worth $3,174,599.[7]

In sum, the US Congress created a perpetual tax-free money machine for inter-generational wealth transfers when it created the Roth IRA.

And it’s available to moderate income folks who can manage to accumulate significant assets in their Roth IRA.

Please see related posts on the IRA:

The Humble IRA

IRAs don’t matter to high income people

A rebuttal: The curious case of Mitt Romney

The 2012 IRA Contribution Infographic

The DIY Movement and the IRA

Angel Investing and the IRA

[1] At the higher level of inter-generational wealth transfer planning, we’ve got a myriad of tools involving trusts, foundations, and tax-advantaged vehicles for estate planning. The estate tax exemption at $5.25 million sets the floor for diving heavily into this kind of legal, financial, and tax advice. For the lower end of the market, however, the Roth IRA can be a really cool, nearly free, tool. Kind of like using Google Calendar instead of having a personal assistant. Or something.

[2] Start with the chart that begins on page 6 of the IRS document.

[3] An ordinary income tax rate will typically be worse than the 20% tax rate that might apply for long-term capital gains one might have in a non-IRA investment account full of appreciated stocks. One of the tax-inefficient features of IRAs. Which is why Mitt Romney’s (up to) $100 million IRA is not as sweet as it sounds. What I really mean is, it’s sweet, but not as tax-efficient as it sounds.

[4] Another neat feature of this $2,574 is that its tax free because of the Roth IRA, although very few 5 year-old children would otherwise have any reason to worry about income taxes, so it’s kind of irrelevant to the example. I guess little Shirley Temple or Drew Barrymore-type working kids would have benefitted from this income-tax free feature of the inherited Roth IRA.

[5] What I mean is that if inflation runs at 2%, and you spend 5% every year because that’s the mandated endowment draw, your market returns have to consistently beat 7% (5+2!) just to maintain your purchasing power at a steady state. When risk-free bonds return 6% or more – as they did until 2000 and the 50 years before that – a blended risky/riskless portfolio has a decent chance of clearing the 7% hurdle. When risk-free bonds return 0.5% to 2% as they do now, you have to put all of your portfolio in risky assets to have any chance at achieving long-term sustainability with your endowment, or with your retiree savings. Which is kind of uncomfortable, I think. I discuss this further here.

[6] A total, in this example, of $85,456 in income.

[7] With that kind of Roth IRA account, just blast yourself out of a circus cannon into a whole mattress full of cocaine to celebrate your 65^th birthday. Afterwards, remember to gently and respectfully light a jasmin-scented candle for grandma, for her original $200K gift.

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