This is a story of love found, lost and found once again. The characters are The Broke Professional (yours truly), and the most seductive of retirement saving vehicles, the Roth IRA. It’s a story full of sleepless nights, laughter, heartbreak and utter contentment, and not necessarily in that order. Allow me to take you on a journey that will hopefully end in a joyous and carefree retirement.
There are a number of different types of retirement savings vehicles. While retirement seems a long way away for many people, and may never come for others, what makes these accounts so attractive is the tax savings that they can bring, specifically not taxing the growth of your accounts right away. No other accounts do this (besides the amazing HSA). There are essentially three points at which your contributions can be taxed: first is when you put your money in, second is when your money grows within the account and third is when you pull money out of the account. Let’s take the bastion of employer retirement accounts, the 401k. Contributions to a 401k are made with pretax dollars and growth in the account isn’t taxed either. You’re taxed when you pull money out of the account later in life. While being taxed is a bummer, at least with this account your contributions and growth are not taxed.
A Traditional IRA works in essentially the same way as a 401k when it comes to taxes. You are taxed on withdrawal of funds but not on contributions (given you meet the income requirements) or growth of your investments. Traditional IRA’s allow more freedom in choosing investments, however, as 401k’s usually have funds that have been preselected by your employer. I personally contribute regularly to my 401k (my employer offers free money) and don’t contribute to a traditional IRA because I exceed the income limits to take a tax deduction (guess that’s a good and bad thing depending on how you look at it).
This leaves us with the true object of my affection, the Roth IRA. Just like everyone wants to know the key data before you make a decision on a potential life partner, let me quickly go through the relevant nitty gritty of the Roth IRA account:
-The Roth IRA was established by the Tax Payer Relief Act of 1997 and is named after its main legislative sponsor, Senator William Roth from Delaware (God bless him).
-As stated before, contributions to a Roth IRA are not tax deductible
-Growth in the account and withdrawals are not taxed if you meet eligibility requirements, mainly having the account for at least 5 years AND being 59.5 years old.
-Direct contributions (not earnings) can be withdrawn anytime without penalty. This a one of the main features that helped me fall back in love with the Roth.
-For a couple who is married and files a joint tax return, they are eligible to contribute the full maximum amount of $5,500 (for 2014) if they make less than $181,000. This makes the Roth highly accessible to middle/upper middle class families.
-There is also a higher “catch up” contribution limit of $6,500 for those 50 and older (man I can’t wait to turn 50).
Without further ado, here is a dramatic re-telling of my journey back into the arms of the Roth IRA.
For whatever reason, the Roth IRA seems to bring out a lot of emotion in the world of personal finance. Most finance writers agree that 401k’s which provide a match to your contributions and have decent investment options are a good thing. No one will really argue against Flexible Spending Accounts and HSA’s for healthcare. The Roth IRA, however, is truly a love it or hate it affair. Sam at Financial Samurai has a number of posts stating his reasons against the Roth IRA. They are all very convincing, especially this one (It currently has 363 comments!). Jeff Rose, another prominent personal finance blogger as well as a Certified Financial Planner, is on the other side of the spectrum. He absolutely LOVES the Roth IRA, and even started a Roth IRA Movement to get the word around to everybody that would listen. So right there you have two respected writers who have made a career out of finance and have such differing views on the Roth IRA.
So now comes my story. I opened my first Roth IRA in July 2010. It was a year after I graduated optometry school so I figured I should do something with all that cash sitting in my checking account. I was contributing to my 401k to get the employer match and I exceeded the income requirements to get a tax deduction with a Traditional IRA, so I decided to do some research on what else I could do with my money. A number of sites I visited recommended The Bogleheads’ Guide to Investing as an essential read for investing newbies. I picked it up and couldn’t put it down. It really resonated with me. That book provided me with the foundation for my investment knowledge, and I still refer to it from time to time. John Bogle is the founder of Vanguard, so I naturally decided to open up my first Roth IRA with them.
They truly do have the lowest fees and expense ratios out there, which doesn’t make a HUGE difference in your investment results early on but can really diminish your returns when you have a sizable amount of money in your portfolio. Vanguard also makes investing pretty easy and transparent, which is important to newbie investors. I already had a full time job, so I didn’t want to have to spend too much of my free time worrying about investments. Since I knew this was money I wasn’t going to need for a very long time, I decided to fully invest in Vanguard’s Total Stock Market Fund (which I’m still with by the way) to get the most growth potential with very very low fees. I dumped what extra money I had into my shiny new Roth IRA and set up regular monthly contributions.
This initial fling went on for about 2 years, which is when I realized I really really hate student loans. I was faithfully paying the minimum on all my loans but it seemed like the balances weren’t moving. Some of them were actually going higher! I appreciate my education and everything, but I don’t like the idea of a big bank siphoning a chunk of my income month after month. I did some reading on debt repayment strategies and found that the Avalanche method was the best way to get rid of student loans. I started working a few extra days a month, stopped my Roth IRA contributions and put whatever extra I could towards my highest rate student loan. I got rid of the first one in a few months and started attacking the second one. It was great seeing those balances actually start going south for a change.
While I was attacking student loans with all of my might, my Roth IRA was gathering dust. I even withdrew some of my contributions to pay off a student loan that was almost finished and was bothering me. I abandoned her. For two whole years. I did check in on the account from time to time (which was actually growing well since the stock market was going wild), but never really thought to start contributing again. But then I realized I was making a mistake. It wasn’t because the stock market was going up. I know enough not to focus on a few years of growth for money that I will not need for a few decades. I forgot how awesome compound interest was. By reinvesting dividends and letting the account grow tax free for decades, I realized I could probably do a lot better than the interest rate I was getting by paying off my student loans early. I also get a tax deduction every year on interest paid on my student loans, so I can still take advantage of that while it’s still around.
Another realization I came too was that in my fervor to pay off student loans early, I saw that I did not have a whole lot of liquid cash available. I’m still contributing regularly to my 401k so I had a decent amount in there, but I can’t touch that until I’m 60. Most of my free cash was going to pay off student loans, which is great but I’m not going to see that increased cash flow for a few years down the road. While it is not advisable to touch the money in a Roth IRA, the fact that you can withdraw contributions penalty free at any time provides a lot of piece in mind. I do have a regular emergency fund in an online savings account, but in case I may need some more for whatever reason, it’s nice to know the Roth is there.
So as of a few months ago, I decided to start contributing to my Roth IRA again, and it feels great. The good part is that I can still attack my student loans because I decided to trim some expenses and use those savings to contribute to the Roth. I’m not contributing up to the max yet, but my goal is to be able to contribute enough in 2015 (and beyond) to be able to max out my Roth IRA. This combination of increasing my investment contributions, attacking my higher interest student loan debts and trimming my expenses will be the best actions I can take to speed up my journey to financial independence. Any extra money I will see in the form of bonuses, credit card rewards etc will go straight to eliminating student loans or increasing investment.
So there you have it. The tale of my relationship with the Roth IRA is now out in the open for everyone to gawk at. It felt good to get that off my chest as it gives me motivation to keep my financial situation on the right path and hopefully provide some guidance to anyone who will listen.