Here’s how to invest in a Roth IRA to maximize its potential returns
In the late 1990s, PayPal co-founder Peter Thiel invested less than $ 2,000 in founder’s shares in his Roth IRA. These stocks are said to have climbed to around $ 5 billion, and Thiel will not owe tax on the gain if he waits until he is 59 and a half to withdraw the money.
A gain of this magnitude — featured in a recent ProPublica report based on Internal Revenue Service documents – not likely to be reproduced by ordinary investors. But they should follow Thiel’s lead in one regard: Roth accounts are a great place for high-risk, high-return investments. (Thiel did not comment on the report.)
Unlike a traditional individual or 401 (k) retirement account, Roths are funded with after-tax dollars. All the money you withdraw from a Roth individual retirement account is tax-free, as long as you are at least 59 and a half years old and have had a Roth account open for five or more years.
The Roth, because it can deliver decades of tax-free growth, is usually the last account you should empty in retirement. This makes it an ideal location for volatile investments like emerging market or small cap stocks.
“Risky things should outperform over time, as long as you can handle the commute,” says Ann Gugle, chartered accountant and financial advisor in Charlotte, North Carolina.
Tax considerations should not determine your investment choices. How much of your savings you put in risky assets and how much you put in safe assets should be determined by your risk tolerance, your investment goals and your stage of life. But once you’ve decided on a financial plan, taxes are key in deciding which assets go into which accounts.
Gugle says she generally separates her clients’ funds into three compartments: Roth accounts; tax-deferred accounts; and taxable accounts. She then begins to fill each bucket as if she were playing a “Tetris game”. Risky investments are best for Roths or, if tax-efficient, for taxable accounts. Income producing investments like bonds or real estate investment trusts, as well as less volatile stocks, or better for tax-deferred accounts.
The exact investments in which accounts differ from person to person, financial advisers caution. For example, bond investments generally make more sense in a traditional IRA than a Roth IRA. This is because they grow slower than stocks. You will end up being taxed on withdrawals from a 401 (k), so it is best to put your fast growing assets in the Roth account, where you will not pay any tax when you withdraw the money someday.
But if you are a conservative saver heavily invested in bonds, you may end up holding bonds in your Roth if you run out of room in your 401 (k) for them based on your target allocations. And if you are an aggressive saver who stakes everything in stocks, you could end up holding a volatile equity fund in your 401 (k) because you no longer have room in your Roth account or taxable account for it. .
If you had a choice between a really big Roth account and a really big deferred account, I think we would all go for the big Roth account.
The limits for contributing directly to a Roth are relatively low, $ 6,000 per year for those under 50 and $ 7,000 for those older. And to make this full contribution, singles cannot earn more than $ 125,000 while married couples cannot exceed $ 198,000.
But many employers now offer workers the option of contributing to a Roth 401 (k) instead of the traditional tax-deferred 401 (k). The Roth version makes particular sense for younger workers or others in a low tax bracket; they often have an interest in paying taxes now rather than deferring them into the future. And the contribution limits are much higher for Roth 401 (k) than for Roth IRA. Workers can contribute up to $ 19,500 per year to the 401 (k) version, or $ 26,000 if they are over 50.
In addition, some pension plans allow workers to make an after-tax contribution and then transfer it later to a Roth account, in what is called a “Roth mega backdoor”.
“It’s really important to look at the details of your plan,” says Gugle.
Many retirees, meanwhile, now have large Roth accounts thanks to Roth conversions. Congress removed income caps for conversions in 2010, suddenly making the maneuver accessible even to wealthy seniors.
During these conversions, you transfer money from a tax-deferred account to a Roth account while paying income taxes on the money transferred. Conversions often make sense for people entering retirement who have not yet started collecting social security and who are in a relatively low tax bracket. By transferring money from their tax-deferred accounts, they reduce their minimum required distributions when they turn 72.
“If you had the choice between a very large Roth account and a very large tax-deferred account, I think we would all choose the large Roth account,” says Mike Piper, a certified public accountant from St. Louis who advises clients on tax planning.
The Roths are also gaining popularity with retirees who want to pass their wealth down to the next generation. Money withdrawn from a Roth by your heirs is tax-free and they have 10 years to empty it after your death. Spouses, minor children and some others are not subject to the 10-year limit.
Whether you’re 25 or 65, the strategy doesn’t really change for which investments a Roth belongs. You want assets with the greatest potential for growth for the rest of your life and the decade after if you plan to pass it on to your heirs. William Bernstein, a Portland, Ore. Fund manager and author of “Investor Manifesto,” keeps only small cap funds and value funds in his own personal Roth IRA.
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“The Roth should get the riskiest, most profitable (and least tax-efficient, in the aggressive category) assets for two reasons,” Bernstein wrote in an email. “1. It has the longest time horizon. 2. It avoids the most taxes.
Leo Marte, financial advisor from Huntersville, NC, says Roths may also make sense for actively managed funds where fund managers make large transactions. If you hold such a fund in a taxable account, you will pay taxes when the fund manager exits a winning position.
“You don’t want actively managed funds in a taxable account because you’re going to get killed,” Marte says. “Much of the income will go to taxes. “
Taxable accounts are good places for tax-advantaged funds, like total market funds, which have a low turnover rate, says Larry Swedroe, co-author of “Your Complete Guide to a Successful and Secure Retirement”. Taxable accounts are also good for assets that can experience large fluctuations in value.
“The more volatile an asset, the more value it has in a taxable account because of the potential to reap losses for tax purposes,” says Swedroe, research director at Buckingham Strategic Wealth. “That way Uncle Sam can share the pain of the loss.”
Nonetheless, Swedroe says savers should maximize tax-efficient accounts, including Roths, before funding taxable accounts because they are the best way to build wealth over time.
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