Friday, February 1, 2013

Roth IRA

This week I started a Roth IRA as a supplement to the taxable account in which I currently hold all my stocks. For readers who don't know, a Roth IRA is a retirement account in which contributions are made with after-tax money (currently up to $5,500 per year), all dividends and capital gains within the account are tax free, and withdrawals are tax free (after age 59 and a half). The tax-free status of the Roth IRA is its main advantage over a taxable account, where dividends and capital gains are currently subject to a 15% tax rate. In a Seeking Alpha article that explored different factors that affect the long-term compounding of dividend income, I showed that dividend growth is slowed by taxes, so it is beneficial to hold stocks in tax-advantaged accounts.

I had been thinking about starting a Roth IRA for a while, but I held off because of uncertainty about my future employment -- there was a nontrivial possibility that I would be either unemployed later this year or working in a different country. Fortunately, that uncertainty disappeared a few weeks ago when I managed to get a new job (starting in the summer), as discussed in a recent post. With greater clarity about my employment and income, I decided it was time for the Roth IRA.

My plan is to fully fund my Roth IRA each year and use the money to buy dividend growth stocks, making the account a tax-advantaged extension of my current portfolio. The only difference between investment decisions for my Roth IRA and taxable accounts will be with respect to dividend yield. I currently require a 2% minimum yield for stocks in my taxable account, whereas I will require a 3% minimum yield in my Roth IRA. The rationale is to keep higher-yielding stocks in the latter account to take greater advantage of its tax benefits.

I have already made a contribution to my Roth IRA, putting in the full $5,000 allowed for 2012 (which can be done prior to April 15). It was easiest to do it in one shot, but that meant supplementing my January savings with about $3,000 from my emergency cash reserve. I will replace that money with my February and March savings. Later this year I will contribute the $5,500 allowed for 2013.

Once I start my new job I plan to rollover the two retirement plans I have with my current employer into my Roth IRA. The first is a 403(b) with TIAA-CREF that has about $14,000 and the second is a 401(k) with Vanguard that has about $6,000. These amounts solely reflect employer contributions over the past five years and the money is currently invested in target date funds. I will have to pay some taxes because the rollover money comes from pre-tax contributions; my calculations show that I will stay in my current marginal income tax bracket if I do it this year, whereas I would be in a higher tax bracket next year because of the higher salary at my new job. Even though the tax hit will hurt, it is a one-time expense that I will save for in advance. The upshot of the rollover is that it will add nearly $20,000 to my Roth IRA, which will allow me to buy a lot of dividend growth stocks. Thus, by the end of this year, I could potentially have around $30,000 in my Roth IRA ($5,000 from my 2012 contribution, $5,500 from my 2013 contribution, and about $20,000 from rollovers).

In case you are wondering, the taxable account with all my current dividend growth stocks will continue to grow over time. My next few purchases will be in my Roth IRA, but once my 2013 contribution is made and I have covered all my moving expenses during the summer, I will resume adding new capital to the taxable account from my monthly savings. Some readers may recall that last year I saved over $17,000 for investment. If I manage to maintain or increase that amount going forward, then I would be able to add over $10,000 to my taxable account each year, after my Roth IRA contribution. Given its higher starting balance and larger contributions, my taxable account will produce the majority of my dividend income over time.

The last point leads to an important question regarding investing and retirement: What if I want to retire early? If I retire before I'm 60, then I would only be able to withdraw direct contributions from my Roth IRA, which would entail selling some stocks. I would not be able to withdraw any earnings, such as dividends, without incurring penalties. This sounds like a disadvantage, but only if you ignore the fact that I will also have a much larger taxable account. If my taxable account produces enough dividend income to retire early, then I wouldn't need to worry about age restrictions on my Roth IRA. When I do turn 60 (actually, 59.5), I would gain access to a second, tax-free dividend income stream. Thus, I don't think having a Roth IRA will adversely affect me in the event of early retirement.

I will start reporting information about my Roth IRA on this blog once I make my first purchase. Given that it is separate from my taxable account, I will distinguish between them when reporting transactions, dividends, etc.


  1. Good move...I think its too easy to focus on the early retirement mantra and forget about the huge bite the tax man will be taking every year, its smart to diminish that

    1. HYS: Thanks -- it will be nice to have a small but tax-efficient "mini-machine" to go along with my main dividend growth machine.

  2. DGM,

    Good stuff. I may be in the minority here by not actively choosing not to participate in a ROTH or other IRA, but it sounds like you did a thorough analysis and this will work out best for you in the long run. A ROTH is a fantastic tool, so I'm glad you'll be using it to your advantage.

    I find that by living on less than $30k a year in dividends I'll be paying a very low amount of income taxes anyway, not to mention the fact that I'll be paying $0 in Medicare/SS or other payroll taxes. I live in Florida, so no state or city income tax either. Yay!

    Glad to see you have the job hunt behind you and now you can look forward to some stability. Sounds like this is a great move for you.

    Best wishes!

    1. DM: Thanks for your comment. Your reasons for not having a Roth IRA make sense. Due to the annual contribution limits, I don't anticipate it being a major source of my future dividend income, but it will help a bit in reducing my future taxes.

  3. If I really do reach early retirement, I plan to spend the dividends in my ROTH the same as my taxable account. Just have to be careful not to withdraw more than I originally contributed. Since I've already been funding my ROTH for about 5 years, and plan to work about 15 more, it should provide nice income for an early retirement.

    I do not know if a 401k rolled over to an IRA, rolled into to a ROTH IRA would count as contributions you can withdraw early. You might want to look into that before hand. I'm sure you have some investment gains there.

    I have both my taxable and ROTH with the same brokerage which allows me to view them as one. That's why I don't seperate it on my blog.

    Smart move to do the rollover in 2013, before your income increases 2014 from a full year at the new job! Genius!

    1. CI: Thanks for your comment. I learned that rollover money is not counted as a "contribution," which has two consequences. First, it means I can still make a direct contribution of $5,500 for 2013. Second, it means I cannot withdraw the rollover money without penalties (but I can still do early withdrawals of my direct contributions, if necessary).

      I also have my taxable account and Roth IRA at the same brokerage. They are treated as separate but linked accounts, so I don't get a combined summary.

      I am pleased that the rollover should work out nicely for tax purposes by doing it in 2013 instead of later. There's no point giving the IRS more money than I need to!

  4. I am sure you already know, but make sure to figure all the taxes when you do your direct Roth IRA conversion I estimated my rate based on my federal rate. In fact it includes all the taxes (federal/state/social sec./medicare).

    Just FYI

    1. Anonymous: Thanks for the tip. The taxes are unfortunate, but I will save some cash to pay for them.