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Why Roth IRA Is The Freaking Awesomest

Posted By Jim On 11/07/2007 @ 5:58 pm In Retirement | 4 Comments

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 Much of the information is outdated (mostly the contribution limits and income phaseouts) however the reasoning is still good and I wanted to preserve it for posterity so I didn’t edit a single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!?


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