The Snowball Effect: Investing in a Roth IRA

The Snowball Effect: Investing in a Roth IRA

As a financial advisor, I know of no reason (other than lack of funds) why one should not invest in a Roth IRA. If you have available cash in the bank, then it would be a good idea to transfer it to a Roth IRA account. If you have funds invested in stocks or mutual funds that are in a regular taxable account (i.e., not in an IRA account), then move the proceeds into a Roth. Each year, you are limited to contributing only $5,500 (or $6,500 if you are over 50 years of age) to your Roth account. If you are married, then only one spouse needs to have earned income that year to qualify both spouses for a Roth IRA contribution.

If you had contributed to your Roth IRA every year since 1998, then you would have contributed over $80,000, which would have been growing income tax-free. In addition, if your income is over $200,000 annually, the money made in the Roth would not count toward the net investment income tax of 3.8% (also known as the Medicare tax on unearned income). To break it down, the average individual pays between 15% and 50% income taxation on taxable bank and brokerage account earnings, depending on income and state residence. The typical taxpayer pays approximately 25% on savings and investment earnings. The Roth is totally tax-free.

Contributing to a Roth account is like building a snowball. When building a snowball, it first grows slowly yet then develops quickly, but occasionally it breaks apart, and you need to patch and re-roll. The growth of your snowball can be compared to the compounded growth of your money invested in a retirement account. The breaking apart of the snowball represents the taxation of the interest on growth each year. With a Roth IRA, your snowball is completely immune to breakage and is never too big to keep rolling—that is the power of investing in a Roth IRA. It is worth considering either gifting your children money to invest in a Roth IRA any year in which they have earned income or educating them to fund their Roth IRA at a young age so that they can capitalize on this “snowball effect” of tax-free compounded growth.

Nothing is more frustrating for me than to meet a potential client who is not invested in a Roth IRA, despite a large amount of regular after-tax savings and/or brokerage assets. Because you can only contribute up to $5,500 or $6,500 per year to a Roth, the client has forever lost years of potential tax-free compounding. It is true that you can convert from an IRA account to a Roth, but you must first pay income taxes on the converted amount, which may not be wise.

Another advantage of investing in a Roth is that you can always get your contributions back if needed without tax or penalty. For example, assume that between 16 and 26 years of age, I have invested $20,000 in my Roth, which has grown over the years to $30,000. If need be, I would be able to take back the $20,000 at any time without tax or penalty. Only the $10,000 of growth (from dividends, interest, and capital gains) would be taxable and subject to penalty if no exception applies.

Investing in a Roth IRA is one of the best retirement accounts that you can invest in. Start investing in a Roth as soon as possible and encourage your children to start even sooner.