So who is this Roth guy and what is a Roth IRA? In 1997, the Taxpayer Relief Act established the Roth Individual Retirement Account. The legislative sponsor was none other than William Roth. This arrangement is significant for one reason: taxes.
Your 401(k) works on a “pre-tax” basis. You get to deduct your contributions on your income taxes, thereby reducing your tax liability. You’ll pay taxes though when you take distributions during your retirement.
A Roth IRA works in the opposite way: you cannot deduct your contributions from your income taxes now, but when you take distributions in retirement you don’t pay any taxes. You’re also not forced to take distributions like you are with 401(k)s. This can make a Roth pretty attractive. Like the 401(k), your Roth IRA grows tax-free.
Ok, but how does this matter? Taxes now or taxes later. You’re still paying taxes! That is correct, but how much you pay in taxes can change. A Roth often makes sense if you’re in your “lower income” years of just starting off in your career.
It also matters from a tax diversifiction standpoint. Just like diversifying your investments, it makes sense to diversify with regard to taxes. Taxes can be raised or lowered in the future and it’s best not to be betting all-or-nothing one way or another. By using both a Roth IRA and a 401(k), you’re accomplishing tax diversification.
The maximum Roth contribution for 2015/2016 is $5,500. I’ll make it easy for you: to reach this limit, contribute $211 per paycheck if you get paid 26 times a year (every two weeks).
Some people get a little paralysis by analysis when it comes to which tax year to send contributions. Like many things, you have until April to make contributions that count towards the previous tax year. Make it easy for yourself: if you’re going to max out your Roth, just start putting in $211 per paycheck and have it count towards the same physical year you make the contribution. Sure, the first year you could have contributed more, but you’ll only have to worry about this problem once.
$5,500 does not sound like a lot to be saving for retirement. But once again, compounding interest works some magic. Let’s say you’re 24 when you start to max out your Roth IRA. At 30, you’ve got kids and have to stop contributing to your Roth because of daycare and other costs. By the time you’re 59-1/2 years old, you’ll have amassed $169,405. That’s a pretty penny for only investing a total of $33,000 over six years.
If you’re able to keep maxing out your Roth each year from when you’re 24 until you’re 59-1/2, you’ll have $633,267 in your account! If you want to play around with your own numbers, use a compound interest calculator.
So what should you invest your Roth IRA in? Just like your 401(k), pick index funds with an expense ratio lower than 0.5%. One of my sets of funds are Vanguard’s Target Retirement funds. They have expense ratios below 0.5% and automatically diversify across the total stock market, international markets, and bonds. They will also automatically adjust to become more conservative as you near retirement. If you want worry-free, target date retirement funds are for you. Just be sure to check the expense ratio. It needs to be less than 0.5%.
Auto-pay really comes into play with maxing your Roth IRA. Why? Because if you don’t have to think about saving, you’re more likely to do it. Having to remember to transfer money each paycheck is a pain. It takes labor. The end goal here is to grow your green and reduce your worry. Skip the worry of saving for retirement by setting up automatic contributions!
- Visit an online brokerage like Vanguard, Fidelity, or Charles Schwab.
- Open a Roth IRA Account
- Select a low-expense mutual fund for your account.
- Vanguard’s Target Retirement funds are a favorite. They are diversified, automatically become more conservative as you grow closer to retirement, and have an expense ratio that is in the neighborhood of 0.2%.
- Put that bad boy on auto-pay. Right when you sign up. Even $50 a paycheck is better than nothing.