July 29, 2014

Roth IRA Investing Guide for 2013

Now that we’ve talked about a Traditional IRA, I am going to turn to its far more attractive brother, the Roth IRA. I’ve written about the topic extensively, especially on the Investing for Beginners site, so this is just a quick rundown for me to reference when I bring up the topic as there is no need to reinvent the wheel. It’s meant as a sort of quick-reference guide for those of you who are considering it and want to have a general idea of how a Roth IRA works before consulting with your own qualified adviser.

The quick version: The Roth IRA is superior in almost every material respect to the Traditional IRA, and offers far greater long-term advantages for the disciplined, rational investor.  Nothing in the history of the United States has come close to offering the scale and scope of potential advantages, if one is smart enough to take advantage of them.

What Is a Roth IRA?

Congress Passed the Taxpayer Relief Act of 1997, which was enacted on August 5th of that year. A provision in that law, named for Delaware Senator William Roth, create a new type of IRA, called the Roth IRA, that was meant to help middle class families build wealth and offer much better benefits than the Traditional IRA.

Like the Traditional IRA, the Roth IRA is an account. It is not an investment. Many financial institutions will allow you to open a Roth IRA. Depending on where you open the account, the service provider will give you the option to invest the money held in your Roth IRA into stocks, bonds, real estate, certificates of deposit, money market accounts, and a few other asset classes.

Each year, Congress limits the amount of money you can put into a Roth IRA, and only allows individuals with incomes below a certain threshold to take advantage of the program (though there is a way rich individual can get around this, which we will discuss later). Roth IRA owners do not receive a tax deduction when they put money into the account. Instead, they get a much better deal. They can withdrawal the principal anytime they want, without taxes or penalty, subject to a few restrictions. Any dividends, interest, rents, capital gains, or other profits generated within the Roth IRA are completely, totally tax-free. Furthermore, under current rules, when you go to retire and begin making withdrawals from the Roth IRA, you will not pay any taxes, at all, on any of the money.

Roth IRA Contribution Limits for 2013

Unlike the Traditional IRA, which is only open to those 70.5 years or younger, anyone with earned income (wages, self-employment income from farming, self-employment income from a business, or alimony) falling below the income levels we will discuss in a moment is eligible to contribute to a Roth IRA.  The amount you can contribute in any given year depends upon your age and is either the lesser of your earned income or:

  • $5,500 if you are 49 years old or younger
  • $6,500 if you are 50 years old or older

The Roth IRA Income Limits for 2013

To make a contribution directly to a Roth IRA in any given year, you must below the income guidelines published by the IRS.  It is important to recognize that these income limits are not your overall pay.  They are based on something known as Modified Adjusted Gross Income (AGI).  When you determine Roth IRA eligibility, you may get to deduct student loan interest expense, tuition and fees, domestic production activities credits, certain qualified bond interest income, certain employer-provided adoption benefits, etc. 

For 2013, you must earn less than the following amounts to qualify to make a direct deposit to a Roth IRA.

  • Single filers: $127,000
  • Head of Household filers: $127,000
  • Married Couples Filing Jointly: $188,000
  • Qualifying Widow or Widower: $188,000
  • Married Couples Filing Separately if You Lived Together at Any Point in the Year: $10,000
  • Married Couples Filing Separately if You Did Not Live Together at Any Point in the Year: $127,000

Once you approach these limits, you may find your contribution limit is less than the full rate most people enjoy.  For example, contribution allowances are reduced for people making the following income (to find the exact amount you are permitted to contribute to a Roth IRA, you would need to have your accountant complete the IRS worksheet):

  • Single filers: $112,000 to $126,999
  • Head of Household filers: $112,000 to $126,999
  • Married Couples Filing Jointly: $178,000 to $187,999
  • Qualifying Widow or Widower: $178,000 to $187,999
  • Married Couples Filing Separately if You Lived Together at Any Point in the Year: $0 to $9,999
  • Married Couples Filing Separately if You Did Not Live Together at Any Point in the Year: $112,000 to $126,999

Note: If you are self-employed, these limits could be achievable even if your income is much, much higher.  You can take all sorts of write-offs ordinary employees can’t, such as deducting the amount you’ve contributed to a SEP-IRA, home office business deductions, health insurance premiums, etc.  It’s entirely possible your household could be earning $300,000+ and, under the right circumstances, still have a Modified AGI figure that makes you eligible to contribute to a Roth IRA.

Making Withdrawals from Your Roth IRA

When you are ready to make a withdrawal from your Roth IRA, your tax situation depends on your age.  The principal amount you contribute to a Roth IRA can be withdrawn from the account any time you want, without tax penalty, even while you are still young.  You cannot, however, redeposit the money if you take it out of the confines of the Roth IRA’s protection.  In practice, that means that if you’ve contributed $100,000 to a Roth IRA over the years, you could tap that entire $100,000 without any tax consequences, whereas with a Traditional IRA you would have been slammed with Federal, state, and local taxes, plus a penalty tax. 

You will be subject to Federal, state, and local taxes plus a 10% penalty tax on any non-principal Roth IRA withdrawals (that is, money in the Roth IRA that did not come from your after-tax contributions, but instead from dividends, interest, rents, capital gains, and other profits) unless the withdrawal is considered “qualified”.  To be qualified, the money being withdrawn must have exceeded a 5-year tax period, and meet one of the following conditions:

  • Made on or after the day you turn 59.5 years old
  • Made after you become disabled as defined by the IRS regulations
  • Made to cover qualified expenses for first-time homeowners
  • Made to your beneficiary or estate following your death

The Benefits of Using a Roth IRA for Your Retirement and Wealth Building

The accountant-types amongst you have already spotted some of the brilliant ways the Roth IRA can be employed to drop the effective tax rate of a family building wealth down to far below where it would otherwise be.  To highlight the possibilities, let’s use a fictional scenario.

Imagine a married couple is 25 years old.  They decide they want to contribute to Roth IRAs until they are 65 years old, then live off the dividends, interest, and rents.  At average rates of return, they would likely end up with somewhere around $5,000,000 by the target date.

Arbitrage the Tax Code Through Asset Placement: An intelligent couple could invest the money in higher returning assets to effectively arbitrage the tax code through a method called asset placement or asset positioning.  High quality corporate bonds yield more than high quality municipal bonds because the latter are tax-free.  However, in a Roth IRA, there are no taxes.  This means the bonds could be allocated to corporate issues, instead, picking up an extra 1% to 2% per year in income.  (That is why you would never buy tax-free municipal bonds in a tax shelter such as an IRA.)

Use the Roth IRA as a Protected Engine to Generate Income then Make a Tax-Free Withdrawal of the Earnings: Remember the Roth IRA has no mandatory withdrawal requirements.  That means you can keep the principal working within one for as long as you are alive.  In this case, the couple could continue to hold as much money as they wanted within the Roth IRA, so the dividends, interest, rents, and capital gains are tax-free, then make withdrawals of those earnings whenever they needed money.  If they took this approach, they could live off the $200,000 per year and have an effective tax rate of 0%.  They would owe nothing to the Federal, state, or local governments despite earning hundreds of thousands of dollars each year.  It’s enough to make Mr. Monopoly himself get excited:

Mr Monopoly Roth IRA

Increase Your Chances for Asset Protection: Although there are no guarantees, and exceptions always exist, in bankruptcy causes the courts tend to hold a great respect for an individual’s retirement accounts, including a Roth IRA.  If you are going to get wiped out or experience a major setback such as a lawsuit in which you are found liable, other than a trust fund established by a third party to which you have no withdrawal rights, a Roth IRA built up over many years is probably one of the safest places for your money if you want even the glimmer of a hope that your debts will be discharged without taking everything you hold.  You may lose your home, you may lose your car, you may lose your checking account, but your Roth might - might – survive if you get a sympathetic judge.

Bypass Probate: A Roth IRA has a named beneficiary that you get to determine.  That means it is more powerful than your last will and testament.  In fact, if someone is listed as your beneficiary, the retirement account should bypass probate entirely upon your death and pass to the person listed with your brokerage firm or financial institution, regardless of what you say in your will, even if it is more recent

Conclusion About Investing Through a Roth IRA

The bottom line? In my opinion, investing in a Roth IRA is superior to every other form of investment holding, including outright brokerage ownership, if you are putting money away for future decades.  The only major downside is that you cannot claim capital losses as tax deductions, meaning you should not be speculating or buying anything other than high grade assets that throw off surplus cash (a rule that you would be wise to consider for your entire portfolio).

There is a lot more to these plans so you should consult a qualified tax professional, such as a well regarded licensed CPA.  There are ways to use IRA conversions to get around the income limits and transform an old Traditional IRA into a Roth IRA.  There are ways to take advantage of self-directed options that permit you to buy real estate assets and private businesses within a Roth IRA.  There are certain other exceptions, or complications, that might arise due to your individual situation that creates a unique set of circumstances not covered here (which is why I am only providing a general high-level overview to provide some familiarity with the account itself and will never provide specific advice or recommendations to anyone).  At the very least, if you qualify, you should consider adding a Roth IRA to your financial toolbox as, over the decades, it can result in some phenomenal advantages.   

  • Bill

    Hey Joshua, I’ve been having a hard time finding a clear answer on this and was wondering if you could shed some light. At 28, the contribution limit for my Roth IRA is $5,500. My wife and I file married jointly. To my understanding – both of us can contribute $5,500 to a Roth IRA in a given year for a total of $11,000. The question I have is – if I am the only one working, and we file married jointly – can I contribute $11,000 to the single Roth IRA? Thanks.

    • http://www.joshuakennon.com/ Joshua Kennon

      To my understanding: No. Absolutely not.

      You should be able to contribute up to $11,000 per year, but you must put $5,500 into your Roth IRA, and $5,500 into her Roth IRA if you qualify for the “Spousal IRA” rule (which most married couples do).

      The rule may sound arbitrary but it makes sense. It was a social safety net designed to protect the stay-at-home spouse in the event of a divorce; your money is your money and her money is her money. Otherwise, a working spouse could take advantage of the stay-at-home spouse’s allowance and then leave him or her broke later in life when he or she ran off with a mistress or the pool boy.

      The section on Spousal IRAs straight from the IRS website:

      “If you file a joint return, you and your spouse can each make IRA contributions even if only one of you has taxable compensation. The amount of your combined contributions can’t be more than the taxable compensation reported on your joint return. It doesn’t matter which spouse earned the compensation.”

      That is why I tell my friends and family you should almost never concentrate the retirement assets in the name of a single spouse. If something ever went wrong in the marriage, the other one has almost no recourse in a divorce. This is why brokerage forms require the spouse to consent to setting up the account and sign off on the paperwork – once that transfer is made, the money belongs to the beneficiary of the IRA alone.

      • Bill

        Oh whoa. I assumed that a Roth IRA would be split in half during a divorce like the rest of any other assets and such. I suppose the reason this is not the case, is similar in reason as to why a Roth IRA is somewhat safe during a bankruptcy? That could definitely make issues come up for the other spouse later down the road if the couple was to part ways.

        So a Roth in each of our names, and then we can contribute $5,500 to each out of only my income. Thanks for the clarification, Joshua!

        • http://www.joshuakennon.com/ Joshua Kennon

          A lot of people assume that is how it is because the courts can and do split retirement plans in certain circumstances during a divorce proceeding and a lot of times there is a somewhat fair outcome. Also, it can be done in the event of an amicable divorce where both parties agree to a certain arrangement and the courts sign off on it. In fact, the IRS is pretty fair about it because as long as there is a court decree authorizing the transfer, you can bypass the taxes that would have been owed (no early withdrawal or other taxes).

          So it’s definitely in their power but my problem is there is no guarantee. If something bad happened, and there was a lot of acrimony, you’re going to spend countless sleepless nights not only worrying about a failed marriage, but wondering whether you will be able to get any of the money you helped save. Most judges try to be fair, but it’s so arbitrary that it makes me very nervous for the non-employed spouse. Why accept something that doesn’t have to be? The arrangement has no advantages but, in a remote scenario, could turn out very poorly for one of the two parties involved.

          I think my strong emotion on the topic comes from being riveted by the divorce of Gary C. Wendt, the CEO of GE Capital back in the 1990′s. That man was married to his wife for decades. She helped put him through business school, gave up a career, ironed his shirts, threw dinner parties, and then he decided he wanted a divorce. The fact that anything less than a full 50% split of assets was even considered revolted me (I was a weird teenager – I really did walk around at 15 years worrying about the public policy implications of this case; about the value we placed on the human capital contributed by non-working spouses and what it said about us, as a civilization, if we discounted those contributions to raising children.) The judge finally gave her half of most of the assets and future pension benefits, but much less than her side had estimated the estate to be worth. I still remember the initial outcome.

          Sorry for the tangent. I didn’t mean to go down that road. The big problem would be if you kicked all $11,000 into a single Roth, you’d get hit with the so-called “excess contribution penalty tax” on the $5,500 that should have gone into your spouse’s IRA. It’s a 6% surcharge tax that gets applied every year to the overage amount within your Roth IRA as an additional penalty until it is corrected or you apply it to the following year.

        • http://www.joshuakennon.com/ Joshua Kennon

          Since you like this sort of thing, this will answer all of your questions. It’s an online IRS Reference Guide for the Roth IRA complete with 2012 and 2013 tax year information. It explains the excess contribution surcharge, spousal IRA, rollovers, conversions, etc. It’s a great read and very well written.

        • Bill

          Awesome, Joshua, thank you.

          Yeah, it’d be a terrible thought that a spouse would be lost out on everything they helped to build. Thanks for the link too!

  • Anon

    Agreed. Also, for most people, Vanguard is the smartest choice imaginable.

  • joe pierson

    Last time I did an excel spreadsheet of Roth vs Traditional, the end results were exactly the same, the benefit of not paying any tax on any Roth withdrawal was canceled out exactly by the opportunity cost of the deduction you lost on the Roth deposits.

    • http://www.joshuakennon.com/ Joshua Kennon

      In certain limited circumstances, that might appear to be the case on a first-pass analysis, depending on the assumptions used for the starting year, the year of first withdrawal, the amount of withdrawal, the return on assets, the income tax bracket at the time of contribution, the income tax bracket during retirement, the tax rate in effect on capital gains and dividends during the holding period, etc.

      However, even if the ending period values appear identical in one of these rare scenarios, you then must factor in the net present value of the ability to take advantage of the tax placement strategy between the first date of no-penalty access (59.5 years old) and death.

      Let’s imagine that two investors end up with identical net worths of $10,000,000 by the time they are 59.5 years old. The first used a combination of a Traditional IRA and a brokerage account. The second used a Roth IRA. Let’s further assume that they stick their money in a combination of blue chip stocks and bonds yielding an average of 4% per annum on the portfolio.

      Now that they are in retirement, both investors are earning $400,000 pre-tax. They have the same net worth. They have identical portfolios. It appears that there was no difference between the Traditional IRA and the Roth IRA.

      However, under present tax laws for most of the country, the first investor might have to pay as much as $100,000 or more in on-going dividend and interest taxes on his $400,000 in annual income, whereas the second investor could continue to keep the entire portfolio parked within the shelter of the Roth, then make a $400,000 withdrawal tax-free at the end of the year. Every year, the portfolio pumps out another $400,000, which he can withdrawal tax-free. If both investors live to average life expectancy, this will result in a lot more wealth for the second investor during his lifetime. If he were so inclined, the second investor would probably be able to put away at least an extra $1.5 to $2.0 million in trust funds for his children and grandchildren arbitraging that tax placement difference despite having an identical net worth to Traditional IRA investor. For the first investor, that isn’t an option.

      (This is the reason I, personally, prefer the IRS methodology for calculating net worth. I would argue that even though these two investors both have $10 million on paper, the second actually has a net worth that is significantly higher. The Federal Reserve statistics, on the other hand, do not capture this economic reality.)

      Plus, there is some value, however difficult to calculate, in the flexibility afforded by accessing the principal contributions without penalty at any time during the lockup period. Arriving at an intrinsic value for this figure would be extraordinarily difficult but it does have value, and it is not insignificant.

      • joe pierson

        But in your case the traditional IRA investor would have a much larger “net worth” at the beginning of retirement, say $12,500,000 vs $10,000,000 for the Roth investor, because the larger yearly tax deferred deposits would of been compounding over the years quicker than the Roth. The Roth always starts out in a “hole” (assuming each investor is investing the same percentage of his gross income). So the traditional IRA investor would be getting $500,000 every year, using $100,000 to pay for the taxes, both ending up with the same after tax income. Their adjusted real net worths are identical after the economic realities of the situation are captured.

        If you compare Roth vs Traditional with equal amounts deposted each year making the same yield, the Roth will always look better (which I think is what you did), but that’s artificial, because the Roth investor is investing a larger percentage of his gross income, which of course isn’t a fair compairson.

        I agree with the added flexibility of the Roth rules, but those rules I don’t believe are that stable, in my opinion, to justify a reevaluation of intrinsic value. (but I can’t quantify that conclusion!)

        • cwntrader

          Joe, keep in mind that with a traditional IRA, you will face the minimum required distribution past 70.5. If your account has grown large enough, you may not need the full minimum distribution each year, in which case the Roth would be the best route because its funds would keep compounding without being taxed.

          Joshua, have you heard of anyone creating a trust fund that doles out yearly income to descendants through a Roth IRA if they are eligible? Is it possible to direct cash that way? You could continually bypass taxes – since the money from the trust would have come from your Roth, and each yearly contribution limit would be far less than the gift tax amount. This would allow descendants to have a guaranteed retirement fund, one that if they were desperate or less savvy could draw from – but take penalties.

  • scott

    What is the risk that congress may someday decide to tax Roth Ira’s ?

    • http://www.joshuakennon.com/ Joshua Kennon

      Excellent question. This is a good summary of the issue.

      There was some talk a bit ago of limiting the IRA balance to $3,000,000, any amount over which must be distributed, because it is so good of a tax shelter that it can become excessive if an individual is intelligent. People threw a fit and it was quickly and quietly killed so I think it would be politically difficult to achieve. More likely, I would think tax bracket rates would rise first.

  • Anonymous (C)

    Thanks for these IRA articles. It’s good to know one can (apparently) contribute to traditional IRAs without being subject to income limitation. You mentioned “there is a way rich individuals can get around the [Roth IRA income limitation], which we will discuss later.” How does one do that?

    • Jay Tank

      Google “Backdoor Roth IRA,” it’s fairly straightforward, and only recently implemented, since 2010 if I recall correctly.

  • Jim

    Dear Joshua

    Can a Roth IRA utilize a margin brokerage account?

    Can a Roth IRA borrow money?

    • http://www.joshuakennon.com/ Joshua Kennon

      No.