I've declared 2018 the year of the Roth IRA. All Roth all the time. If you aren't contributing to a Roth IRA in some way, you might be missing out in a big way!
What is a Roth IRA?
As long time readers know, I am a Roth IRA evangelist. Even in my fervor, I do recognize that the Roth IRA might not always be the best idea for everyone. I often settle for it being the best idea for most people. However, in the year of our lord 2018, the Roth IRA is an even better deal for more people than it has been before.
To understand this, lets look at how a Roth IRA works compared to other investment accounts.
A Roth IRA is a tax free account. While you pay taxes on your income, once you put money into the Roth, it grows tax free and can be withdrawn (subject to a few rules) completely tax free. This is a really good deal for investors who hope to grow their accounts massively over a long period of time.
Another type of account is tax deferred, such as a Traditional IRA or many 401(k) style accounts. With accounts like this, you get a tax break just for putting money in, the account grows tax free, but you pay income tax on the withdrawals. These are great if you are in a high tax bracket now, as you get the tax break immediately, and defer your tax burden into the future.
The last type of account is what I call a Taxable account. There are no special tax rules around it. You can put as much money in and take as much money out as you like. The only taxes you pay are on the growth of the investments that you make. There are some tax advantages here as investment gains typically have favorable tax rates compared to income, but there are no breaks or tax reductions with this type of account.
Roth IRA deposits effectively come from your income. You pay taxes on your income. Once you have money in the Roth IRA, you can invest it however you like, generally in some combination of stocks, bonds or cash.
The idea with an account like this is to let it grow for a long time so that you can have money to support yourself in retirement. If you put in $1,000 and invested it such that it grew at 6% for 40 years, you would have nearly $10,000. If you set said $1,000 each year and earned an average 6% growth, you would have about $80,000 at the end of only 30 years! The compounding of higher growth rates is real.
In general, you pay a little tax on a little money, and a lot of tax on a lot of money. Also, the more money you pay tax on, the higher the rate. Putting all of this together, you can see the that the Roth IRA is very beneficial if you expect 1) your account to grow and 2) you might be in a similar or higher tax rate later. This is why I generally recommend a Roth IRA for young folks and people who have a long time to let their money grow.
Back to your burning question, why now? Well, thanks to the modest tax cut that everyone is receiving, everyone is suddenly in a lower tax bracket. Additionally, since the tax cut is only temporary, we KNOW that we will be in a higher tax bracket later (for the same income level)! So, while we are in this lower tax rate world for the next year (or so? unclear) it is time to take advantage of the Roth IRA!
How can I contribute?
There are three ways that you can contribute to a Roth IRA. Each one makes sense for different people.
If you have earned income (if you are working) then you can make regular contributions to a Roth IRA. You are allowed to contribute up to $5,500 each calendar year (If you didn't earn $5,500 then you can contribute up to your total earnings). This will apply to most people who are working and not earning more than the income limits. The income limits for 2018 are $120,000 if you file taxes as a single person and $189,000 if you file taxes jointly.
So what do you do if you are working but making more than those income limits? There is a trick. The trick is called a backdoor Roth IRA. You make a non-deductible contribution of up to $5,500 to a regular IRA, then convert it over to your Roth IRA. This is not, strictly speaking, tax advice, but this trick exists in a vaguely grey area. This follows all of the rules, but also looks like you are just trying to get around the income limits. Which, you are. Talk with your tax advisor about this before pulling the trigger.
What if you are not working anymore? Can you still contribute? Actually, yes! There is one more way to contribute! If you have tax deferred accounts, you can convert them into Roth accounts! This makes sense if you have built up a large 401(k) or personal IRA and are near retirement. Maybe you are in a lull between your last big paycheck and your first little social security check and you technically have no income. This is an ideal time for you to convert some of your old tax deferred account into a Roth account. A conversion is simply taking money out of one account and putting it in the other, all in one stroke of a pen (or click of a button, if you are using the Internet). Now remember from above, if you take money out of a tax deferred account, you will owe income taxes. You must take that into account with this strategy. You don't want to convert a large chunk of tax deferred money into a Roth if you are in a high tax bracket already - that would maximize your taxes! You want to convert when you are in a low tax bracket. Take advantage of a temporarily lower tax bracket (like, say, the ones this year!) and shift money from an account that is all tax, to one that is NO tax. Ideally, this is done when you have a large tax deferred account and are working with a low tax bracket for a year or so. Pay lower taxes now and never pay taxes again!
So how do I do this?
If you made it through that last paragraph and you are still paying attention, congratulations! I hope that you think everything I said is really great and you are totally on board with my thinking. If not, you should really stop reading and do something else with your time. If you are on board, lets get down to the details!
First you are going to need to open a Roth IRA. You can open a Roth IRA at pretty much any financial institution, but since the benefit is really maximized with good growth from stock investments, look for a discount broker or work with an investment advisor who can help you with the process. We use TD Ameritrade and I also like Charles Schwab for retail investors. Robo-Advisors like Wealthfront and Betterment also have decent offerings. Click around on things that say "open an account!" and that should lead you down the right path.
Second - you will need a way to fund that new account, so have your bank account information handy. You can add money as a lump sum all at once or set up a regular transfer from your bank account to your brand new Roth. The Roth IRA is a personal account, so you probably won't be able to do payroll deferrals. You are all on your own, so make sure that you have everything set up correctly.
Next, when you deposit money into a Roth IRA you will need to designate what tax year it is for. Since you have up until tax time to get money in for a given year, January 1 - April 15ish will give you a choice of either the current calendar year or previous calendar year. If you are trying to maximize your deposits, go ahead and max out last year (in line with the income rules!) and then tackle the present. Keep in mind your annual contribution limits. Most brokerages should have something in place to prevent you from over contributing.
Lastly, if you have a self guided account, you'll need to get that cash invested. Robo-Advisors will do the work for you based on a little questionnaire about your age income and risk tolerance. Schwab generally provides some guidance if you click around enough, but focus on simple, low cost funds that you can set and forget. Both Schwab and TD Ameritrade have a slate of index funds that are free to trade, making it easy to build a well diversified, low cost portfolio.
I can't tell you how to invest your portfolio right now, as I don't know anything about you. Generally speaking, the longer you are from needing the money, the more aggressively you can afford to invest. For an all stock portfolio, split it roughly between US and Foreign stocks. On the US side, your biggest allocation should be to Large Cap stocks as they make 80% of the market (conveniently, defined that way) the rest can be split between small and mid cap funds. On the foreign side, developed foreign funds should be the bulk with the difference made up of emerging market funds.
If you're within 10-20 years of starting withdrawals from the account, it may be prudent to allocate some money to bonds and cash.
It is best to work with a professional to establish and understand the appropriate allocation.
The Roth IRA is the best deal going in tax avoidance, and this year is even better than usual. It is definitely worth everyone looking at opening and contributing to one to secure your future. Depending on your income level, you may even be eligible for a tax credit for making the deposit!