An individual retirement account or IRA is a type of savings/investment vehicle that receives tax incentives from the US government and the IRS, in synthesis it allows individuals to either defer tax or benefit of tax-free capital gains from their investments.
In order to understand better what a ROTH IRA is, it is important to have an overall notional of what a Traditional IRA is and why it is key for individuals to take advantage of its benefits at an early stage in their life/career.
Just like with most investments, time will be an important factor for success and performance. Early investors usually receive a considerable advantage since earnings from contributions are reinvested into the account, resulting in a powerful compounding cycle. It’s easy how as the years go by the value of an IRA can grow exponentially.
While an IRA might not be enough for an individual to cover all of their retirement expenses, it offers space as a complementary model that also allows for savings and the ability to invest in the financial markets with a tax incentive that otherwise wouldn’t be possible. Most individuals commit the mistake of leaving their retirement plans for later in their life and this usually hinders their possibilities taking full advantage of an IRA.
In the long run, it’s not just how much money you make that will determine your future prosperity. It’s how much of that money you put to work by saving it and investing it. Peter Lynch
In this article, we will cover the key differences and factors that differentiate a ROTH to any other type of IRA. Even though most types of IRAs offer a basic principle, it is important for individuals and investors to be aware that no two individuals are the same and that principle also applies to accounts. Choosing an account cant be taken lightly and requires for any individual to do their own research and analyze deeply their risk profile and also their taxes.
Roth IRAs vs. Traditional IRAs Explained:
In a traditional IRA the tax incentive is, in reality, a tax deferral, this means that individuals would be able to defer their taxes until the funds are withdrawn from the account. With this model taxes will be paid based on the final funds, meaning that you would also be paying taxes over the contributed capital and any earnings incurred.
While this model benefited investors that later in their life would be in a lower tax bracket, it did the posit for individuals whose bracket was higher. In order to provide a relief mechanism and a fair ground for individuals that were suffering from this situation, the Taxpayer Relief Act of 1997 established the ROTH IRA.
This newly created vehicle offered individuals the ability to contribute after-tax money, this means that any contribution made to the account has already paid its due taxes. With this model, taxes were paid upfront instead of being deferred towards retirement. Another key element is that any profit or earnings generated from investing the contributions and the balance of the account are tax-free.
Even though tax-free capital gains seems like a better option than deferring the tax, it is important to consider and keep in mind that the amount contributed which is technically the seed capital that will eventually be invested and compounded will be smaller and this can affect returns. It is not the same to invest $6,000 consistently and receive the return generated by the full six thousand, to paying taxes upfront and only investing $4,000 after paying 25% on taxes.
To understand which one is the best options for an individual, it is necessary to understand and plan based on the overall picture and not the IRA. In other words, investors should consider and run both scenarios and select the one that represents the best model in the long run.
At the end of the day, IRAs are supposed to be fully enjoyed at retirement, planning considering the time until retirement age is only appropriate in order to take full advantage and avoid expensive mistakes like choosing the wrong taxation model.
What are the Pros and Cons of a Roth IRA?
One of the best parts about an IRA is that even though the model of the account is not perfect, there are many different alternatives to choose from. If you take your time to review the different IRAs and you know what your necessities are, it is highly probable that you would end finding an option that will fit most your profile and your needs as an investor.
If we focus on the ROTH IRA alone, there are many advantages that can easily lure an investor into choosing it but once again and just like with any other investment vehicle, it is not perfect. Here are some of the most important pros and cons of choosing a Roth IRA as your complementary retirement account:
- There’s no need for required minimum distributions: This means that even if you are age +70½ you won’t be mandated to withdraw from your account as in a regular or Traditional IRA.
- You can withdraw your contributions: Even though we do not advise in taking early withdrawals from a retirement account unless it is ultimately necessary, Roth IRAs allow investors to withdraw their contributions since the money used in the first instance was already tax-free. It is important to keep in mind that this does not take into consideration profits or earnings generated by the investment of any contribution, any performance withdrawal will incur in a penalty unless it is done after retirement.
- Earnings and performance are tax-free at retirement: Imagine being lucky enough to invest in a startup with your ROTH IRA capital and seen the stock of company easy doubling itself several times before your retirement. The best part of this scenario would be to know that you don’t owe a dime in capital gains to the government! The reason for this would be that you paid the taxes for your ROTH contributions upfront, this is why it is very important to take your time before choosing your retirement account.
- Low Maximum contribution: Just like with any other IRA, the max contribution level is actually pretty low as it only allows individuals to contribute up to $6,000 a year and with an additional extra $1,000 once you are over 50 years old.
- Taxes are paid up front: It’s most important asset its also its major pain for many individuals, as mentioned above ROTH accounts both IRA and 401K requires the investor to pay its taxes upfront in exchange of waiving any income tax from capital gains. This can either be the reason for you to choose the Roth IRA over a Traditional or will be the deal breaker.
- Eligibility for a ROTH IRA is based on income: Not all individuals are eligible to open or contribute to an existant ROTH IRA once their annual income surpasses as a predetermined level. For example, if you are single and you earn more than $137,000 a year you would not be eligible for contributions.
What are the Limitations of a Roth IRA?
Not every individual or married couple is eligible to start an IRA, this is due to a very strict limitation for individuals with a high annual income. Even though there are many limitations, the structure is pretty straightforward:
Please note that Filing status is the major denominator for this rules/limitations.
1. Married filing jointly or qualifying widow(er)
- Less than $193,000 | Max contribution of $6,000 or 7,000 if 50+
- Between 193,000+ to $202,999 | Contribution is Reduced
- More than $203,000 | Not Eligible
2. Single, head of household or married filing separately
- Less than $122,000 | Max contribution of $6,000 or 7,000 if 50+
- Between 122,000+ to $136,999 | Contribution is Reduced
- More than $136,999| Not Eligible
3. Married Filing separately
- Less than $10,000 | Contribution is Reduced
- More than $10,000| Not Eligible
Define your Investment Style
One of the many questions I usually receive when talking to a new investor or someone who is starting to do their first steps in the financial markets is about which investment style is better? I usually like to answer by asking them back which style is better for who? Many individuals usually forget that before choosing an investment method or style it is important to understand your goals, risk appetite, and even your personality first.
Luckily for many, the financial markets offer a vast range of investment vehicles and assets to choose from, without any hesitation, I can say that there is an asset class for most individuals and that a style will depend on the risk aversion of the individual.
Without getting into the heavy detail about investment strategies and risk profiles, I recommend most individuals to decide between hands-on and hands-off styles respectively. Even though these two styles might seem too simple, in reality, the cover an important range of the market.
Not all individuals have the intention or the desire of spending hours doing research and reviewing their portfolios actively. It is actually pretty common to see investors looking for professional asset and fund managers to take control of their accounts in exchange for a percentage fee. While this might be a relatively expensive option, it offers a passive model that allows individuals to lay back a bit more.
Just like you can find individuals with no intention of participating actively, some others do not have what it takes to let a third-party manage their investments. This is a key point where personality is truly a show stopper for certain personalities and styles. Unless you are a professional trader or you have a vast knowledge and experience in the financial markets, you might be better off with an asset manager as it will take a lot of responsibility off your shoulders.
This model brings back the notional that an IRA is a retirement account, while the main goal many individuals have in mind is to profit, in reality, they should be a focus on capital conservation and saving as much for retirement as possible.
Best Roth IRA Providers and Brokers of 2019
Continuing with the same structure, these are the best providers and brokers for Roth IRAs in 2019. In order to provide better detail, we’ve separated the names between both hands-on and hands-off models.
Best IRA Accounts for Hands-On Investors:
1. TD Ameritrade
The Thinkorswim platform was created in the late nineties by Tom Sosnoff, a veteran investor and trader who believed that the investing in stocks and derivative instruments could become popular to retail investors with the help of a completely dedicated software.
After a decade of its founding, Thinkorswim was sold to TD Ameritrade. Officially becoming the spearhead over which the broker was renewed. TD Ameritrade is one of the most important brokers in the US, with total assets exceeding $1 Trillion in more than 11 million client accounts.
Even if you are new to the financial markets or simply to investing, the name Thinkorswim might be one of the first ones you heard or read about online as it is one of the best overall brokers available in the market. With more than 11 million active clients and assets under management exceeding $1 Trillion in the US alone, TD Ameritrade is one of the most respected options available today.
Investors should be aware the TD Ameritrade is definitely not the cheapest option when it comes to opening an IRA, but the firm surely compensates their high price with a first class experience to its users. One of the main reasons investors should look into this broker is due to all the service they provide besides brokerage and retirement planning.
In order to ease some of the cost associated with trading fees, the company offers to charge on their IRAs, meaning that no other commission besides trading fees will be charged.
In today’s fast world it is very useful to be able to consolidate many important services under one single environment. Most notable services available in 2019 are:
- Life Insurance
- Retirement and Wealth Management
- Commercial Banking
- Auto Financing
- Direct Investing
- Active Portfolio Management
Technical and fundamental analysis are the two elements over which most investors develop their strategies, and structure their portfolios. Thinkorswim exceeds expectations with a swiss knife application that not only is powerful but is also intuitive and friendly to all investors.
If you have used a Bloomberg Terminal in the past, you will find yourself close to home with Thinkorswim. On the other hand, if you have never been close to a terminal it might take you some time to understand how to use it, but it is definitely not difficult.
In order to mitigate the impact on new users, the firm offers a vast library of educational content which makes it even easier for new users.
Fidelity is one of the most powerful brokers in the world, managing more than $2.46 Trillion in assets as of May 2019. One big concern I typically have when choosing a broker is to understand the history behind the company, I want to know that my money is backed by years of experience and never by a new broker.
With 75 years of existence is easy to see that Fidelity has survived several market crashes and economic recessions, this can only prove even more how stable and seasoned the company really is.
If you are looking to manage your IRA on your own, Fidelity is a good option for anyone interested in following a passive investment methodology/strategy. Even though the company provides access to a vast range of financial indicators and technical analysis tools, they still lag behind names like TOS or Individual Brokers.
Just like TD Ameritrade, the firm looks to improve its expensive image by not charging any account management fee. With this model investors only have to focus on the fees charged by the broker due to trades execution and regular brokerage business.
If you are interested in the US markets, you should consider fidelity as they offer other products besides brokerage, making it a full package for international and local investors.
Some of the complementary services are:
- Retirement and Wealth Management
- Cash Management
- Derivatives Products
- Active Portfolio Management
Fidelity might not be the cheapest option but it delivers access for both active and passive investors, making it a well balanced and safe option.
TradeStation is a top-notch platform that covers most of the necessities a trader might have. Even though the firm started as a broker focused only on institutional and heavy players, the company has changed its model allowing retail investors to gain access to their state of the art service.
The company offers access to the major financial markets and asset classes in the world, allowing investors to diversify into other markets besides the US.
Investors should keep in mind that TradeStation does not offer portfolio management services, leaving investors under their own management and execution.
Trade Station is the cheapest option of the hands-on category, the company currently charges only $4 per trade and offers free real-time market data which has a cost of about $120 a month with any other broker.
Best IRA Accounts for Hands-Off Investors:
1. The Vanguard Group
The vanguard group is a giant multinational with over $5.3 trillion in assets under management. The company is the largest provider of mutual funds in the world and the second ETF provider, only behind BlackRock’s iShares.
Since its inception, the founder of the company Jack Bogle preached for financial markets and investment opportunities to work in the most straightforward and efficient way as possible. This is the exact same vision the company follows until today, as they focus on delivering the best possible return in the most transparent way.
Vanguard model works like a top tier Robo-advisor enhanced specifically for investors looking to allocate large sums of capital in the markets. Professional advisor services aren’t cheap, but the services and performance delivered are worth for any investor to pay the high fees.
For 2019 the average expense ratio is 1.01% of the value of the account, while for Vanguard is only 0.18% making it considerably cheaper than the overall market.
The company understands that every investor is different and that all portfolios should be developed based on every investor profile, goals, and tolerance. For this reason, the firm takes extra steps in order to assign a profile to each investor after an examination, this profile will take into consideration goals, risk appetite and sophistication of the investor in order to determine the best course of action.
Betterment is not a broker but the company offers its services as an online financial advisor and portfolio manager. Their business model is simply perfect for anyone interested in a handoff IRA. With more than ten years of service, the company has proven to be a reliable option for anyone looking to passively profit from the markets and to pass the responsibility of managing the portfolio to a third party.
An important characteristic to mentioned about Betterment is that any investor with an account under $100k won’t have access to investing in single stocks and instead would have to go for specific ETFs that deliver a more robust return at a smaller unit of risk.
Over the past couple of years, Betterment has worked in a joint venture with the giant asset manager BlackRock, to design a low-risk high dividend portfolio specially developed to generate income.
This portfolio has become a solid option for retirees looking to receive stable, income as well as a method to preserve their capital.
As of January 2019, the company had +$115 Billion in asset under management and more than 400,000 active users worldwide, making it one of the most important and fully automated advisors worldwide.
WealthFront is another option for anyone interested in delegating their portfolios to a third-party for management. It is common to see individuals that are too afraid to invest their money or that simply do not have the experience either the knowledge on how to do it. The firm offers portfolio management services through a Robo-advisor model under which the portfolios are rebalanced automatically based on the parameters of an algorithm.
One of the key features of the company is their user-friendly platform, the overall environment is easy to easy and it was designed specifically for new investors with little to no experience in the financial markets.
An IRA is a very dynamic type of account, to the point where individuals are allowed to convert their accounts between IRA Types. For instance, lets picture and individual with a Traditional IRA, After doing his own analysis he realizes that he should have open that account as a ROTH instead many years back. In his current account, he has only deferred taxes, meaning that his contributions have not been taxed at all. In order for him to proceed with a conversion, he would have to pay the upfront taxes of his contributions. The amount to be paid will be calculated on the current tax rate of the individual.
This is the simplest model, hasn’t paid taxes and will have to pay them in order to do the conversion. On the other hand, if you are a ROTH IRA owner, and you would like to convert your account into a Traditional IRA, then it would a different story. Under this model you have already paid taxes for your contributions, this means that you would be spending an account that will be taxed again later in the future.
In my experience, individuals usually commit the mistake of avoiding the tax talk or truly understand their tax situation going forward. But if you have made the right choice and you opened an IRA, it is key to see the big picture before many any decisions. At the end of the day, you don’t want to look back in the past and realize that the choice you made is costing you a significant amount in the future.
As mentioned before, there are not many reasons for an individual to pass on an IRA if they are eligible for one. If you choose the right investment vehicle your future self will truly appreciate the effort of saving and investing as the chances of improving your retirement increases dramatically.
Look at your IRA as a long term investment, it will help you avoid the temptation of early withdrawals and the boredom of watching paint dry. If you have the right approach it can become exciting to see how your contributions compound with the earnings and your money grow.
An IRA will be as good as your commitment to it and to your account selection. There are no perfect investment vehicles, but with enough research, it is easy to see which ones fit better to an individuals profile and expectations.
Take your time understanding how IRAs work and specifically if a Roth Account is what suits your needs better.
Tax advantages will differ between the type of the IRA. In synthesis an IRA will permit an investor to defer their taxes until the money is withdrawn from the account, effectively parking and reinvesting the money.
On the other hand, Roth IRAs will need an upfront payment over the money invested, making any profit made with the capital tax-free.
Please take your time investigating and doing your own research before choosing an IRA account, this is especially important as returns from different account types can vary significantly based on the tax bracket of the owner.
In order for any individual to start an IRA, it is needed to contribute a one-time fixed fee of $500. After this initial payment, all contributions will be open to each individuals capacity and the overall limit annually.
When it comes to the operation and the cost associated with the account, there is no fixed rate and it will depend based on the broker and the services that you would be using from them. Many investors that are interested in the cheapest option usually go for a hands-on broker as the only charge will be the fees from the transactions. While this might be a relatively cheap option unless you have the right knowledge and experience over how to manage your portfolio it would be recommended for any individual to choose a broker that offers portfolio management.
Since IRAs are regularly sponsored by the federal government, it is fairly common to see brokers offering their products at cheaper price than it would cost for a regular investment account. Top tier asset managers charge on average up to 2% of the value of the account for their services. This might sound like a lot but once you consider the returns they are offering and the ability to pass the wheel to someone else it is actually a very good deal.
This is usually a tricky question, if you were asking broadly if you should own an IRA I would immediately say yes without any hesitation. On the other hand, owning a Roth IRA would ultimately depend on your profile and goals.
Keep in mind that with this model you would be contribution after-tax cash, this means that you will be paying taxes upfront for any contributions. While this is strategy broadly used, it also has its own problems or simply negatives since the contributed money that will act as seed capital is being reduced due to taxes.
Since the main logic behind an IRA is to be able to benefit from compounding and savings, a higher contribution will improve your chances to receive higher returns as your capital grow and reinvest its own earnings.
Conversations can be costly as in many cases you would have to pay taxes on the balance of the account as a whole. In order to decide if it is suitable or even a good idea it is important to understand deeply the tax profile of the person and to do the right calculations.
Life is not stationary, your living condition can improve as you got older and this can also mean that your tax rate can become higher. If this is the case and you are expecting to be ruled by a higher tax rate than you are now, you might wanna consider doing a conversion as you would be paying taxes on your contributions at a lower rate and earnings and performance would be tax-free.
Please note that if for any reason the money contributed for a traditional IRA was post-tax money, then you wouldn’t be accountable for paying taxes in order to convert to a ROTH account. It is extremely important to talk to a financial or tax advisor before taking a decision like this, it might not be cheap but compared to the money it can save you, in the long run, it is totally worthy.
There is no restriction for individuals in terms of the number of IRAs they can own and contribute to, but the limitations and max contribution number of $6,000 will have to be respected. It is recommended for an individual to understand their risk profile, age, goals, and retirement age expectancy as well as tax rates in order to develop the most suitable strategy.
It is fairly common to see individuals splitting their contributions between accounts, balancing in order to gain the best possible usage of their taxation benefits.
Most Brokers and Providers will offer consultation as part of their initiation process, I highly recommend anyone interested in any type of IRA to ask for a profile review in order to determine the best line of action and the right approach to their investments.
Traditional IRAs do not allow individuals to contribute after age 70½, it is at this point when they are instead supposed to start using their capital in order to compensate for their retirement cost. Roth IRAs, on the other hand, allow individuals to continue contributing as long as they are working or employed.
While the basic principle of an IRA is to save for when retirement age comes, many individuals also have other principal retirement plans, making an IRA an extra and not really a full necessity in order to cover expenses. For more wealthy individuals a ROTH IRA will allow them to continue contributing and investing their money for as long as they work.
This is a repetitive question I receive most of the time, and the answer is “No”. You can’t compare the benefit of receiving a matching contribution for free and the higher contribution limit of a 401K. Having said so, it is not a matter of deciding which one is better than the other but to actually understand that they can work simultaneously. Individuals are allowed to have both IRAs and 401Ks at the same time. Why not taking advantage of both vehicles?
In order to determine the eligibility of an individual for an IRA it is key to understand their income and marital status.
Please note that according to the IRS any individual that receives taxable income and it’s under 70½ will qualify as long as their income does not surpass its respective limitation (see box above).
IRAs allow individuals to invest in a pretty broad range of assets classes and financial markets. While most investors will certainly aim for one of the asset classes in the money market, some others decide to go for more exotic instruments in search of better returns for their money.
If you decide to open your IRA with a Hands-off broker you will most likely be asked certain questions in order to determine your risk profile and appetite, this will help the decision making of where to invest your capital and at what level of risk.
Many individuals are usually disappointed because they are not receiving the returns they expect, while there are many different asset classes with average annual returns that can easily range between 13% and higher, it is important to keep mind that just like with any other investment in life at a higher risk a higher return.
Most portfolio managers will usually build a tailor-made model on which an individual can be well balanced and diversified between asset classes, allowing them to benefit from riskier assets without any overexposure.
Please note that there are certain restrictions in terms of the assets that an individual can invest, some of the most common restrictions are going to be imposed on collectibles assets like:
- Works of Art
- Rugs or Antiques
- Metal or gEMS
- Stamp or Coins
- Alcoholic Beverages
- Any other tangible personal property specified by the IRS
It is worth mentioning that certain bullion coins issued by the US like the American eagle are not considered collectibles due to their legal tender status, this allows individuals to invest in them and waive the collectibles restriction.
The IRS makes illegal to directly invest in these so call “collectibles”, but it also allow investors to buy any type of securities that use collectibles as underlying assets. Over the years its become pretty popular to buy ETFs whose value is directly pegged to the assets held by the fund. These are literally hundreds of funds with this model, ranging from vintage wine bottles to classic Ferraris. Note that due to their peculiar business model, these ETFs usually charges a very expensive management fee.
The financial markets are unpredictable animals, it is difficult if not impossible for anyone to try to predict them every year. But what can be done is to analyze the returns of each specific asset class over a long period of time, while this does not guarantee profits to be made every year, it provides color to what to expect over a considerable long period.
Keep in mind that the success of an IRA can only be measured over time, you will have a hard time if you suffer every up and down in the market.
For example, if you were to analyze the stock market and its annual return over the past 30 years, you would find that on average the S&P has yielded almost 12%. If you were to invest in ETFs or mutual funds that track the market this is what you could expect over time.
On the other hand, sectors inside the market can yield high double-digit returns when the market is in a rally, so it will really depend on how much risk you are willing to take.
Reial Estates investment Trusts have usually beat the S&P in bull markets, but once add bearish environments to the average they usually yield in excess of 10% every year. Just like in ’08 prices of real state can tank heavily and this is one of the factors that influence returns over time. Note that in bullish environments prices can easily hike up to 20+ in one year.
Fixed Income market has historically been the go-to option for any investor looking for a constant and stable income. While many individuals only focus on US-backed securities like Treasury Bonds, Treasury Bills, Municipal Bonds, there are many other types of bonds that can easily pay a higher yield like Corporate Debt and even HighYield-Junk bonds. On average Bonds usually, pay up to 5% annually, fair from betting the stock market but the return will be fixed in many cases.