Roth IRAs were invented in 1997 to supplement Traditional IRAs, and in some situations the Roth presents a better overall financial opportunity. There are many reasons to consider using a Roth IRA. Some people make too much money to deduct a Traditional IRA, but others (in low tax brackets) also favor using the Roth IRA. Investors just starting to save money may realize that a Roth IRA can be used for a variety of beneficial pre-retirement financial transactions not available using the Traditional IRA.
In appropriate circumstances, we are huge supporters of the Roth IRA. BUT, experience has shown us that far too many Roth IRA owners are under-utilizing their own wealth accumulation potential. Here are a few common errors:
- Confusing the account with the investment. This is common in banks and credit unions, when the customer is convinced to open an IRA that simply winds up in an interest-bearing CD.
- Investing too cautiously. Roth IRAs are perfect vehicles in which to maximize investment risk, as the returns over time, no matter how large, will never be taxed.
- Failing to maximize contribution potential. Unlike Traditional IRAs, Roth IRAs can accept contributions after age 70-1/2, assuming that the owner (or the owner’s spouse) has sufficient earned income to cover the contribution.
- No Required Minimum Distributions, or RMDs, need to be taken during the life of the owner. Beneficiaries will have to take RMDs after inheriting a Roth IRA, but the withdrawals will be small, and the proceeds will not be taxable.
The true wealth-building opportunity offered by a Roth IRA is unlocked by maximizing both lifetime contributions and investment risk. Every investor should understand the relationship between risk and reward. “No pain, no gain” is ubiquitous in the physical fitness industry, but is also applicable to investing. In both cases, more is gained over time by taking more risk, which means increasing the variability of returns in an IRA.
Riskier assets, such as stocks, have a track record of higher, but less predictable, returns. Money market funds, CDs, and the like offer predictable, but much smaller, returns. Over time, higher average returns from stocks should provide a more favorable outcome. With no required withdrawals, Roth IRAs may continue to grow throughout a lifetime, and then be inherited tax-free by beneficiaries.
The purpose of a Roth IRA (or any tax-qualified retirement account) is to grow it as much as possible over time. Retirement funds will help replace your income once you reach retirement. Invested properly, a Roth IRA is the perfect vehicle for aggressively growing retirement funds. Merely parking Roth IRA contributions in an interest-bearing account for years is tantamount to carrying buckets of water from one end of a swimming pool and dumping them into the other end. Why bother?
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