Why Roth IRA Is The Freaking Awesomest

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I just discovered this post, one that I had written on February 11th, 2005 (that’s right, that’s like forty years ago) but never published, deep in the “Drafts” collection. That’s right, it ranks as one of the first few posts I’d ever written but strangely enough it never made it out of Drafts. Much of the information is outdated (mostly the contribution limits and income phaseouts) however the reasoning is still good and I wanted to preserve it for posterity so I didn’t edit a single word. (It was hard not to edit it!)

If you haven’t heard about a Roth IRA, you’ve been missing out on one of the best tax-free growth vehicles you can possibly take part in. The government caps it, so you know it must be good. We will discuss the Roth and compare it to the other retirement juggernaut (if you don’t count what Social Security, Medicaid and Medicare are supposed to do) called a 401K.

Let’s get to a little history and the basics and then move into why the Roth is so awesome. In the Taxpayer Relief Act of 1997, the Roth IRA was created and taxpayers rejoiced.

The Basics:

Based on a max-contribution schedule (that increases each year and is detailed below) and your annual income, each individual is able to contribute the lesser of 100% of their annual compensation or $4,000 (for 2005). Individuals over 50+ can contribute a little more to “catch-up.” Distributions from the Roth IRA are tax free. The funds in your Roth IRA can be used to purchase almost anything from stocks to bonds to CDs, etc.

The Schedule:

For 49 and under – $3,000 for 2002-2004 (You can still contribute to a 2004 up until April 15th); $4,000 for 2005-2007; and $5,000 for 2008. You can deposit it all at once or bits at a time.
For 50 and over – #3,500 for 2002-2004; $4,500 for 2005; $5,000 for 2006-2007; $6,000 for 2008. So the “catch-up” is from $500 to $1000 a year.

Now comes the analysis…

Roth or 401K?

This is a question that has been hotly debated for quite some time. My personal opinion is that you should contribute to the minimum required to receive an employer match, then maximize your Roth IRA for the year, and then max out your 401K for the year. I have no children so 529 and similar plans were never a consideration in my decision. Another assumption I have made is that by the time of my retirement, I will have an annual income greater than the one I have no and so my tax bracket rate will be higher. (If I didn’t assume that, it’d be like aiming for mediocrity don’t you think?)

Breaking down the decision:

  • Minimum Matching Contribution to 401K – This is a no brainer, if they are giving me free money then I will take it. I doubt much discussion is necessary on this one.
  • Roth IRA Maximum – If my tax rate is higher later than it is now, I want to put in my money at the lower rate and allow it to grow and then later paid out at a tax rate of 0%. If my tax rate is lower in the future, then I would reverse the 401K and the Roth contribution limits. Since I don’t trade stocks in my 401K and I purchase funds, the Roth let’s me “gamble.”
  • 401K Maximum – I don’t max out my 401K because at $14k this year, I can’t afford to not have the free cash flow. Putting a suitable amount in there is nice because it’s money you can’t mess up (only your company can mess it up) and hopefully it’ll be there later. Plus because it’s pre-tax, you’re feeling less of the tax implications now.

Other Considerations:

Another assumption not mentioned in my message is that I have no credit card debt. There is no point in putting anything (except perhaps the 401K match because most people get fifty cents to the dollar, or 50%) in a retirement account if you are carrying credit card debt. With APR’s in the double digits, you are killing yourself if you don’t pay that off as soon as financially possible. In order for that investment to make sense (because you are borrowing the money you aren’t paying back to the card), you need to get a rate of return great than inflation and the interest rate of the card. If you know of a safe investment generating more than double digit rates, please let me know.

What did you all think!?

{ 4 comments, please add your thoughts now! }

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4 Responses to “Why Roth IRA Is The Freaking Awesomest”

  1. MoneyNing says:

    Your organizational and English skills got much better over the years 🙂 The article was great nonetheless.

    It’s always nice to see the changes of a blogger over the years! Thanks for sharing.

  2. Nicole says:

    I think the Roth IRA can be a great tool for savings but if you are sure you are not going to work at all during retirement AND do not have alot of passive or portfolio income it mathematically makes more sense to max out 401K and Traditional IRAs first.

    This is assuming that tax rates stay where they are currently. The reason for this is that we have to look at our effective tax rate and not just our tax bracket.

    Example: Just starting out at 24.5 years old. Mr. Roth & Mr. K both make $80,000/yr. Both are single and do not itemize, and both reture at 59.5 years old (in 35 years). Assume wages, contirbution limits & tax brackets go up with inflation.

    Mr. Roth puts 10% ($8000) of his salary in the 401K, and $4000 in Roth IRAs each year. After taxes and retirement savings, he has $46,880 to live on. If he saves this $12000/yr for 35 years, and gets an 11% return, he’ll have $4,099,074.66 upon retirement

    Mr. K puts 16.5% ($13200) of his salary in the 401K, and ditches the Roth. After taxes and retirement savings, he has $46,980 to live on ($100 more than Mr. Roth). If he saves this $13,200/yr for 35 years, and gets an 11% return, he’ll have $4,508,982.12 upon retirement.

    “But wait”, you’ll say, “Mr. Roth gets some tax free money!”

    By jove, he does. But does it make up for the missing $400K+?

    Suppose both withdraw 4% in their first year of retirement, indexing for inflation thereafter.

    Mr. Roth withdraws $163,962.99 each year. If he draws proportionately from 401K and Roth, then $109,308.66 (2/3) of this is taxable. He will pay $18,267.02 in FIT on this amount, leaving him with $145,695.06 to live on.

    Mr. K withdraws $180,359.28 each year. All of it is taxable, so he pays much more in taxes: $27,274.60. This leaves him with $153,084.69 to live on.

    Hmm. Even when taxes are considered, Mr. K comes out better. I have run these numbers with higher and lower incomes, and it comes out the same. Contibuting to a deductible IRA would have the same impact as the 401K.

    Of course, changes in the tax law could change the outcome of this analysis. So putting some money in a Roth might be a decent hedge. And the availability of Roth contributions prior to retirement age might be desirable. However, I don’t believe you can use 72(t) to get money out of a Roth early.

    I wrote an article about this subject a couple months ago.

    That being said, I choose to fund a Roth because I plan on have alot of portfolio and passive income from other vehicles in retirement along with wmployment income because I know I will never stop working!!!

  3. DebtyBetty says:

    I have a question. I’ve heard that some people open and/or contribute to a Roth IRA if they find out they’ll have to owe taxes, so that they’ll be able to avoid paying them by putting the money in a Roth IRA account. Can anyone explain this? So if, for instance, I’m estimating that I’ll have to pay $1000 in taxes for 2007, how much will I have put in a Roth IRA between January 1-April 14 to avoid and/or lessen the taxes I have to pay?

  4. jim says:

    DebtyBetty – The Roth IRA isn’t tax deductible, so you’ll still have to pay that tax even if you contribute. The Traditional IRA is deductible depending on your situation but that gets complicated but would be possible.

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