Many people praise “The Roth” as if it was the greatest thing the government has ever implemented. Is it really though? Should you open a Roth IRA? How difficult is it to invest in a Roth IRA? What are the benefits? What’s the catch?
We are going to be going over the lifestyle of someone investing in a Roth IRA, and how it affects you as a potential investor.
What is a Roth IRA?
The Roth Individual Retirement Account is an investment account that many people use to maximize their tax benefits and give them a stable retirement.
There are many types of retirement accounts. The Roth fits in the same category as a 401k, a traditional IRA, a TSP, and so on. There are many options, and you can have more than one!
What are the Tax Benefits of The Roth?
A Roth IRA provides tax benefits that young investors can put into retirement accounts.
The rule is that instead of paying taxes on what you withdraw from your retirement account, you will pay taxes on the money BEFORE. This may not sound like a big deal, but it is HUGE depending on what type of investments you are involved in.
Paying taxes before could either hurt or help you depending on what type of investment you choose, so I will go over the investments that it could potentially help:
- Dividend Investing
- Stock Investing
- Mutual Fund Investing
- Index Fund Investing
The honest answer is that it can help or hinder any kind of investment depending on the deal you get in the investment, and the amount you invest.
How Do The Tax Benefits Affect An Investor?
Essentially, if you pay taxed beforehand, that means that you will not get taxed on any dividends you earn. Meanwhile, in another investment account, you don’t pay taxed until you withdraw from the account. This means that you will get taxed from anything you withdraw: contributions, earnings, dividends, anything.
With the Roth IRA, you only get taxed on contributions, meaning that when you withdraw you will not owe any taxes.
I will give an example of a very conservative dividend investor who just invests his money in the NOBL index fund. The NOBL fund has a dividend yield of 2%, and has been consistently raising its dividend every year. The dividend has grown 287% in the last 6 years, averaging out to 47.8% annual dividend growth. However, the numbers have fluctuated at points so we will go down to a very conservative 15% annual growth rate. I will also use a conservative 10% annual return on share price, although it has grown much faster than that. DRIP will be utilized in this example, and I will show you the tax difference.
In this scenario, we will assume the dividend investor makes about $50,000 annually, which puts him in the 22% tax bracket.
If he/she plans on investing the maximum $5500 a year in the Roth, they would pay $1210 in taxes up front. That is a lot of money, however, we will see how it plays out.
So the dividend investor would need to set aside $6710 every year to invest $5500 into their Roth IRA. But now, the dividends and share price will grow freely and never be taxed as long as you meet the requirements.
Assuming all goes well for 40 years, from age 19-59, then you will have produced MASSIVE returns. By age 59, you will be receiving $1.12 million dollars every year in dividends. The best part? You pay NO taxes on any of it!
Is this realistic? It absolutely is, on a smaller scale. What are the chances that the NOBL fund continues to grow half as rapdily as it is now for the next 40 years? Even if it does not, you can still bring in absolutely amazing returns. In no way am I suggesting you invest in the NOBL fund, because individual stocks typically bring better returns. NOBL will slow down, and it will not keep up the same rates for an entire 4 decades.
Weaknesses of a Roth IRA
It sounds too good to be true, doesn’t it? That’s where it becomes realistic.
The reason I used the age 59 in my previous example is because you cannot withdraw any earnings from your Roth until you are 59.5 years old and have had your Roth account for at least 5 years. However, you can withdraw your contributions! This means that you cannot withdraw your dividends, however you can reinvest them depending on the brokerage service you use. You can withdraw the $5500 a year that you may want to contribute.
$5500 a year is not a requirement, it is simply a maximum.
The second problem with a Roth IRA is mentioned by real estate investor Meet Kevin in his video “3 Reasons the Roth IRA Is Ripping You Off”
He talks about how you can earn more by contributing the money that you would initially pay for taxes. If instead of investing that $5500 a year, you instead invested that $6710 a year. There is a truth to that, but it depends on the type of investment.
Let’s run some numbers:
You already saw the potential of the Roth in the previous example, so let’s use that same scenario with a different account. In this case, you will invest $6710 per year and then pay the qualified dividend tax of 15%.
As you can see, you earn less when you pay taxes after the fact.
However, depending on how much you want to invest, going a different route could easily be the better option!
The Roth IRA is a great resource for people to invest in, but it could also be a hinderance depending on what and how you want to invest. Also! The Roth limit was increased in 2019 from $5500 annually to $6000 annually for incomes under $122,000. Keep this in mind!
If you have any questions, please let me know in the comments or send an email to firstname.lastname@example.org!