It is astounding to me to see how many finance articles online speak of Roth 401ks and IRAs as though they are a type of asset that you buy. Instead, it would be more accurate to say that it is a type of account with tax benefits and a few restrictions that you can use to purchase assets on more favorable terms. It is analogous to a contract with the government that gives the investments you make certain benefits so long as you comply with the Roth IRA rules and contribution limits.
Philosophically, all IRA accounts are about making a deal with the government. You are seeking tax benefits that allow you to compound your funds tax-free as long as your money remains in the account. Meanwhile, the government is seeking a guarantee from you that the funds will actually be used during your traditional retirement age so they impose harsh 10% penalties for early withdrawals that also carry taxes at ordinary income rates for non-qualified withdrawals (in addition to waiting until you’re 59.5 years old, there are a couple of other circumstances that permit you to make withdrawals from your earnings such as a home purchase, but your head is not in the game if you already have your mind on ways to withdraw the money early).
The 2017 contribution limit has been set at $5,500 if you earn under $118,000 and are a single filer or under $186,000 if you are married and filing jointly. After that, the permissible amount that you may contribute to your account diminishes each year (for instance, if you are single and make $119,000, you can only contribute $4,950). Once your income hits $133,000 if you are single or $196,000 if you are married and filing jointly, you can no longer add funds to an individual retirement account although you can let your prior contributions continue to grow in the account.
Personally, I think it is a strong signal that you’re getting a good deal anytime the government places limits on the amount that you’re allowed to contribute. It’s like going to the grocery store and seeing one of those “maximum of two” signs on their best sales (though in recent years, they have recognized how this hijacks our psychology and started using it on items that aren’t on sale that much but want to induce the same sense of buyer’s urgency).
Where Is The Best Place To Invest In An IRA?
I think any brokerage house suffices. If you want to use Schwab, Scottrade, or Interactive Brokers, go for it. Given that nearly every discount brokerage house charges under $10 per trade, I don’t think this question has the same importance that it did twenty years.
I would say that you should refrain from using some mutual fund houses that charge $30 or more per trade for stock investments outside of their own funds. Retirement accounts are something you carry with you throughout life and therefore work best when you have the entire world at your disposal for making an investment, and I prefer the generally limitless world of investments that the major discount brokerage houses offer (and since these are your steak and potato retirement funds, I don’t go for the latest startup that offers gimmicky free trades because I think $10 trades are a fair price to pay for the safety of using a brokerage with vast institutional resources).
How Should You Approach Your Retirement Investments?
With a Roth IRA or 401k, the advantage is that your money gets to compound tax free and then be withdrawn tax free. This means that you don’t have to pay the nearly 40% taxes on those real estate investment trust investment dividends. It mean you don’t have to pay 23.8% taxes on your dividends. It means you don’t have to pay 23.8% taxes on your capital gains.
This enables you to simplify your inquiry. You don’t have to figure out which investments offer the best returns after taxes. Instead, you can just ask yourself the question: At the current prices available to me right now, which investments will offer me the greatest compounding between now and the time that the asset is sold?
The way I view it, there are two “modes” you should apply when searching for searching for investments to put inside an IRA account.
First, you should look for high dividend producing stocks when the sector is deeply undervalued. That means doing things like buying Realty Income (O) in 2009 when the stock was at $15 per share. The contribution limit was $5,000 back then, but if you loaded up on 333 shares, you’d be collecting $67 every single month that could be used to go toward new investments. You’d be side-stepping the 40% tax on non-qualified REIT dividends and you’d also be structuring your account to become self-funding so that the $800+ in Realty Income dividends can be a form of self-generating capital to act alongside your next year’s $5,500 contribution so that you effectively have $6,300 to invest.
The same thing goes for oil stocks when they are in slumps. Last year, Royal Dutch Shell stock (RDS.B) traded at $37 per share. With a $5,500 investment, we are talking about 148 B shares getting added to the account. Right now, that would already be adding $556 to the passive income generated from your account. And each dividend that would otherwise be taxed at 23.8% you get to keep and compound.
Of course, the question becomes: What should you buy for your Roth IRA during times like these when no sector of the economy seems particularly undervalued?
Well, you should remember that you get shielded from 23.8% capital gains taxes as well. You should look for the fast growers that offer the greatest prospects of capital appreciation. In fact, you can almost never go wrong investing in a business that has the highest future earnings per share growth while trading at a semi-rational valuation or better.
Imagine if you had a brokerage account option on a 401k in 1990 and put $5,500 into shares of Nike back then? You would have compounded your wealth at 16.2% annually and you’d be sitting on $297,700 in wealth today that is the byproduct of selling athletic apparel and shoes. By putting it in a retirement account, you would be sheltering yourself from $69,543 in capital gains taxes (as capital gains accumulate, the tax benefits of holding them in retirement vehicles accumulates as well). Well, guess, you can add that some amount of money to an IRA investment in Nike stock today. The business is still growing in the 12-17% range, and current investors have a fair chance of coming close to replicating Nike’s awesome historical track record.
Savvy Retirement Account Investing Boils Down To Two Steps
First, you should ask yourself the question: Is there any income-producing segment of the economy that is in obvious distress right now? If the answer is, you should look to that sector. That means REITS in 2009. That means banks in 2010 and 2011. That means large-cap oil stocks in 2015, and possibly even BP stock right now. These businesses give you a nice mix of capital gains during the recovery mixed with high dividends on an ongoing basis that don’t get taxed. But if there is no sector that strikes you as cheap, you should focus on finding corporations with the greatest long-term earnings per share growth like Visa and Nike.
The Roth IRA seeks to serve you by letting you put your best investment ideas behind a veil of tax-free protection. That is your gift from Uncle Sam to go forth, compound, and prosper. Your investment selections deserve some contemplation because of the staggering wealth that can be created over a 30+ year time horizon if you select your assets wisely.