In the late 1990s, PayPal co-founder Peter Thiel invested less than $ 2,000 in founding shares of his Roth IRA. These shares would have amounted to approximately $ 5 billion and Thiel will not owe income taxes if he waits until the age of 59½ to withdraw the money.
A gain of this magnitude, which appears in a recent ProPublica report based on Internal Revenue Service documents, is unlikely to be replicated by ordinary investors. But they should follow Thiel’s leadership in one aspect: Roth accounts are an ideal place for high-risk, high-yield investments. (Thiel did not comment on the report.)
Unlike a traditional individual retirement account or 401 (k), Roths is funded with dollars after taxes. All money you withdraw from an individual Roth retirement account is tax-free, as long as you are at least 59 and a half years old and have a Roth account open for five years or more.
The Roth, because it can offer decades of tax-free growth, is usually the last account you should empty into retirement. This makes it a perfect place for volatile investments, such as emerging market or small-cap stocks.
“Risky things should get over time, as long as you can stand the trip,” says Ann Gugle, a public accountant and certified financial advisor in Charlotte, NC.
Tax consideration should not determine your investment options. The portion of your savings that you put into risky assets and the share that you put into safe assets should be determined by your risk tolerance, investment goals, and life stage. But once you’ve decided on a financial plan, taxes are key when deciding which assets go into which accounts.
Google says it typically separates funds from its customers into three deposits: Roth accounts; deferred tax accounts; and taxable accounts. He then begins to fill each bucket as if he were playing a “Tetris game.” Risky investments are best for Roth or, if taxing, for taxable accounts. Income-producing investments, such as bonds or real estate investment trusts, along with less volatile equity, or better for tax-deferred accounts.
Exactly what investments go into which accounts differ from person to person, caution financial advisors. For example, bond investments generally make more sense in a traditional IRA than in a Roth IRA. This is because they grow more slowly than stocks. It will eventually charge taxes for withdrawals of a 401 (k), so it’s best to place your fast-growing assets in your Roth account, where you won’t pay any taxes when you withdraw the money someday.
But if you’re a conservative saver who invests heavily in bonds, you may have bonds in your Roth if you run out of space on your 401 (k) based on target allocations. And if you’re an aggressive stock-saving saver, you may have a volatile stock fund in your 401 (k), as you’ve run out of space in your Roth account or taxable account.
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If you have a choice between a very large Roth account and a very large deferred account, I think we would all choose the large Roth account.
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The limits for contributing directly to a Roth are relatively small, $ 6,000 a year for those under 50 and $ 7,000 for adults. And to make that full contribution, single people can’t earn more than $ 125,000, while married couples can’t make more than $ 198,000.
But many employers give workers the option to contribute money to a Roth 401 (k) instead of the traditional tax-deferred 401 (k). Roth’s version makes particular sense for young workers or others who are on a low tax bracket; it is often better to pay taxes now rather than defer them to the future. And the contribution limits are much higher for Roth 401 (k) s than for Roth IRA. Workers can contribute up to $ 19,500 annually to version 401 (k) or $ 26,000 if they are over 50 years old.
In addition, some retirement plans allow workers to make an after-tax contribution and then deposit it into a Roth account, in what is called a “Rear Mega-Door Roth”.
“It’s very important to look at the details of your plan,” Gugle says.
Meanwhile, many retirees now own Roth account properties thanks to Roth conversions. Congress removed the conversion income cap in 2010, making the maneuver available even to wealthy seniors.
In these conversions, you move money from a deferred tax account to a Roth account while you pay income tax on the money transferred. Conversions often make sense for people who have advanced to retirement and have not yet started collecting Social Security and are in a relatively low tax bracket. By withdrawing money from their accounts with tax deferral, they reduce the mandatory minimum distributions when they reach the age of 72.
“If you have the choice between a very large Roth account and a very large tax deferral account, I think we would all choose the large Roth account,” says Mike Piper, a certified public accountant at St. John’s. Louis who advises clients on tax planning.
Roths is also gaining popularity among retirees who want to pass on wealth to the next generation. The money Roth takes out for your heirs is tax-free and they have ten years to empty it after they die. Spouses, minor children and some others are not subject to the ten-year limit.
Whether you’re 25 or 65, the strategy doesn’t really change for which investments belong to a Roth. You want assets with more growth potential for the rest of your life and the next decade if you plan to leave them to your heirs. William Bernstein, of Portland, Oregon, money manager and author of the “Investor Manifesto,” only retains small capitalization funds and value funds in his own personal Roth IRA.
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“The Roths should get the riskier, higher-yielding assets (and less tax-efficient, within the aggressive category), for two reasons,” Bernstein writes in an email. “1. It has the longest time horizon. 2. Avoid most taxes “.
Leo Marte, a financial advisor in Huntersville, North Carolina, says Roths can also make sense for actively managed funds, where fund managers do intensive business. If you have this fund in a taxable account, you will pay taxes when the fund manager leaves the winning position.
“You don’t want funds actively managed in a taxable account because they’ll kill you,” Mars says. “Many of the returns will go to taxes.”
Larry Swedroe, co-author of “Your Complete Guide to Safe Retirement,” says Larry Swedroe, that taxable accounts are good places for fiscally efficient funds, such as total market funds, with low turnover. Taxable accounts are also good for assets that can have large changes in value.
“The more volatile an asset is, the more valuable it is in a taxable account because of the ability to collect losses for tax purposes,” says Swedroe, research director at Buckingham Strategic Wealth. “That way, Uncle Sam manages to share the pain of the loss.”
Still, Swedroe argues that savers should run out of accounts with maximum tax benefits, including Roths, before financing taxable accounts because they are the best way to generate wealth over time.
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