When investing within the confines of a Roth IRA, there are two different strategies that an investor can pursue (or combine them both) to work around the $5,500 maximum contribution limit that are allowed to put into the account.
The first strategy involves focusing on growth that you can convert into income later—imagine if you spent a couple years putting $5,500 into something like Visa, Disney, or Becton Dickinson. They tend to grow in the 10-13% range, although neither of the three companies pay a particularly high starting dividend yield at the moment.
If you were to let those three companies do their thing for twenty years, and you had $16,500 left to compound at 12% annually, those three stocks would have a combined value of somewhere around $179,000 in the year 2034. Although Congress will likely raise the rate of annual contributions permitted to a Roth IRA over the years, we can make the back-of-the-envelope that it would take about three decades of putting the maximum allowable amount into the account each year for someone be able to get $179,000 tucked away inside a Roth IRA.
With those kinds of companies that exhibit high growth rates, you get all of that money perpetually behind the shield of the Roth, so you never have to pay any taxes on the distributions you take from the account (the catch is that it doesn’t lower your tax bill at the time you contribute, and you can’t claim any deductions on money lost within the count). That $179,000 could be put to extraordinary use twenty years from now—what if US bond rates normalize towards something approaching their historical tendency, and you are able to slowly convert that capital into something yielding 6.5%? You just created a tax-free cash flow for yourself of something resembling $11,500-$12,000 each year. That’s what optimal tax strategy in a good case scenario looks like.
For other investors, that might want to do something that involves lower growth potential, but offers much better high current yield. This process may result in less wealth, but it creates a better process from which to spend your life working. There’s a lot of companies that fit this profile—AT&T, Altria, Philip Morris International, Reynolds, Conoco, Royal Dutch Shell, GlaxoSmithKline, and BP—but I’ll use BP as an example for our purposes.
The average price of BP for the past three years has been $41.32. Let’s say you were able to set aside three years of Roth IRA contributions into BP (it may not be wise to put it all into one stock, so take this for illustrative purposes of the principle). You would have essentially acquire 400 shares of the oil giant. At the present time, you would be collecting $936 in annual income from the BP investment.
All of a sudden, that BP stock can act as a tool to amplify your future investments. Let’s say you want to buy Johnson & Johnson for your Roth IRA next year—instead of only getting to purchase the $5,500 worth of the stock that you happened to contribute, you would get to purchase $6,436 worth of Johnson & Johnson due to the pooled BP dividends that you combined with your fresh cash.
And that is only one year of BP dividends. Maybe BP will pay out $0.615 each quarter next year (up from $0.585 quarterly this year), and you’d get to combine $984 with your fresh $5,500 contribution instead of $936. Having a couple cash cows like BP in an IRA, dutifully paying out high dividends, provides you an outlet to amplify your cash contributions by making larger investments each year compared to what would otherwise be possible just from the spare cash created by your labor alone. Six or seven years from now, I could easily see BP providing $1,800 each year to add to your investment amounts, making the effects of this strategy grow more pronounced with time.
It comes down to your style: Are you the type of person who thinks, “I will completely delay gratification for decades, and don’t need any rewards on the path until that moment.” If that describes you, the first option might be better. If your thought process is more like, “Hey, I have to set aside a lot of money to make this happen, and I like receiving the little rewards along the way so I can make each year’s Roth IRA investment be higher due to the combination of cash cow dividends I am able to use”, then the second option would be preferable. Investing is a lot more fun when you deliberate and then choose a strategy that matches your personal style while knowing what creates personal satisfaction for you.
Originally posted 2014-09-05 08:00:26.