This is a question about using an IRA to build wealth and comparing it to a regular brokerage account that I promised to answer in the comments section of this post.
Speaking of passing fortunes along to children and grandchildren. I have created a personal goal of constructing a forever portfolio that will pay out dividends to my family for generations to come.
I have a concern that I would appreciate your thoughts on. You often recommend investors to utilize tax advantaged accounts (like IRAs, roths, etc.) to accumulate their portfolio. However, I understand these types of accounts force position sells through the “required minimum distribution” once you meet a certain age. I’ve also read that there is not a RMD for the first owner of a Roth, but the RMD will kick in for the first generation beneficiary. Additionally, I understand using dividends as your RMD would be taxed at the earnings income level, rather than the current 15 or 20% via a taxable (non-retirement) account. Ideally, my goal would be to never sell and live off of the dividends. I’m thinking that if I didn’t have to sell, the power of compounding and dividend growth after 40+ years would become exponential and far exceed the tax hits I am taking today by not investing my surplus in Roths or IRAs; not to mention my total control over the account and to not be forced to sell of a great asset. So I am leaning towards taking the tax hits now and saving/investing all of my surplus dollars (in excess of my 401k min to receive the match) in taxable accounts to maintain this control and set up the family for generations. I would like your thoughts on this long term strategy. A few givens…my wife and I both work, combined we’re in the 28% tax bracket, ages are 36 and 35, own (cashflow w mortgages) a few of residential rentals.
Would you mind sharing your thoughts?
The good news? Your question implicitly assumes that the rules for a Traditional IRA are also in force for a Roth IRA, as well as other types of IRAs. They are not. There are around 5 or 6 popular IRAs permitted by law in the United States. The two most famous are the Traditional IRA and the Roth IRA. Both are not types of investments; they are a type of account. You can open an IRA at a bank and fill it with certificates of deposit. You can open an IRA at a brokerage firm and fill it with stocks and bonds. You can open an IRA at a mutual fund company and fill it with mutual funds. When your assets become particularly large, you can even use a specialized trustee to “self-direct” the investments in your IRA, using them to do things like buy entire apartment buildings, though the rules are extremely complex, you can only own a certain percentage of certain assets, you can’t be involved in the underlying holding, and you can’t use debt or you might get hit with something known as the Unrelated Business Income Tax.
The difference between a Traditional IRA and a Roth IRA come down to how the taxes are handled and the benefits to which you are entitled. You can have both a Traditional IRA and a Roth IRA, but between the two of them, you cannot deposit more than the IRA contribution limit in effect for that year. It was impossible to answer this question without explaining each, so I set aside some time last week and wrote a 4,378 word breakdown of the general specifics of each.
- The first can be read in the post Traditional IRA Investing Guide for 2013.
- The second can be read in the post Roth IRA Investing Guide for 2013.
You will not understand my reasoning unless you have read both of those posts and have an idea of how the Traditional IRA and the Roth IRA stack up to each other in terms of benefits and drawbacks.
With that said, I think there can be no mathematical argument made that a Roth IRA is a vastly superior mechanism compared to a traditional brokerage account when attempting to achieve the objective you describe. Though you’d need to speak to a qualified professional (I do not now, nor will I ever provide tax or financial advice and every reader is responsible for seeking out their own accountants, attorneys, and tax specialists), the general benefits include being able to withdrawal principal contributions without penalty, there are no mandatory distribution requirements, you don’t have to pay taxes on the dividends, interest, rents, and capital gains you earn during the holding period, there are no age limits on contributions, and you don’t have to pay taxes on the money withdrawn as long as you meet the guidelines (e.g., having the Roth IRA open for longer than 5 years and being 59.5 years old or older).
The problem is the limitation on contributions (currently $5,500 for those 49 or younger and $6,500 for those 50 or older; meaning a married couple might be able to contribute as little as $11,000 or as much as $13,000 per annum, presuming they don’t exceed the income limitations) and the fact super high earners can’t take advantage of the Roth IRA.
When you pass away, your children and grandchildren could inherit the Roth IRA and, true, they would need to liquidate the holdings, but there would not tax consequences for doing so. They could turn around and repurchase, almost immediately, the very assets they had just sold through a regular brokerage account, costing only a handful of commissions.
(There is also another option that can be used in addition to the Roth IRA, but it would only work if you had the scale and means to implement it: Setting up your own Roth 401(k) plan. It has almost all of the same advantages of the Roth IRA, except mandatory distributions are required at 70.5 years old. This isn’t concerning since there are no taxes on withdrawals; you could simply turn around and repurchase the very asset you sold to fund the withdrawal. I only mention it because, under the right circumstances, a married couple could put away $100,000+ per year and never pay any taxes on any of the money, even when they start making distributions later in life. I’m investigating how to put them in place for my own businesses at the moment; if it can be done, I’m hoping to make the switch in the next few years.)
The downside of this approach is you can’t enjoy the dividends and other passive income yourself during your lifetime unless you want to begin drawing from the Roth IRA. At your income bracket, though, you should be able to put money aside into other cash generating assets – you mentioned real estate, as well as dividend paying stocks – that are held in regular taxable accounts or forms, unrestricted for your own use in the here and now.
That’s my thought. A Roth IRA crushes a comparably situated brokerage account under the scenario you described. It’s not even close.