When I was a college student conducting research in the Interventional Radiology department, I worked with another college student who was significantly more financially informed than I was. He mentioned to me that he was contributing his earnings to a Roth IRA because growth was “tax free”, and that his parents were planning to do a “parental match”.
Say what?
He further explained to me that his parents were simply going to give him the same amount that he earned from his summer research for spending so that he could contribute his entire summer income to the Roth IRA. I don’t remember exactly how many times he tried to explain the logic to me, but it was pretty clear that my mind was already made. What good was saving a few thousand dollars for retirement as a college student? There was no way my parents (who were not financially savvy either) would go for it, nor could they afford matching me. End of story.
Don’t leave money on the table
It never occurred to me at the time that investing even a small number would become very big after several decades. It pays (literally) to be aware of the small stuff. Had I found a means to obtain a parental Roth IRA match, the $2000 or so that I didn’t invest would easily have become a six-figure amount in my retirement. My effective tax rate at the time was likely 0%, and all of the gains in the Roth IRA wouldn’t be taxed either—it doesn’t get any better than this. Don’t leave money on the table.
You might also like: How to fund your backdoor Roth IRA via E-Trade – 2021 Edition
Roth IRA in a nutshell
We spend a lot of time talking about backdoor Roth IRA’s and the mechanics of funding them, but it’s even more important to understand why it’s a useful investment vehicle. It is the only way for you to decide whether a Roth IRA will fit in your investment portfolio, because there are plenty of physicians who actively oppose funding Roth IRAs. Some of them oppose them due to incomplete knowledge or personal convictions. If you don’t understand how it works yourself, someone else might convince you either way for the wrong reasons.
A Roth IRA is an individual retirement account defined by the Taxpayer Relief Act of 1997. The premise is that you contribute after-tax money to fund the account. This means that there’s no income tax deduction on the amount you contribute, but any gains from investment aren’t going to be taxed. In 2021, the limit that you can contribute to a Roth IRA is $6000 for those under age 50 and $7000 for those above. While this amount doesn’t seem huge, it will be substantial after a career of investing. If you end up needing to withdraw from it in retirement, 2/3rds of its value might actually be gains.
This amount can be significant. Take a look in this simplified example. Suppose you invested $100 in a normal taxable investment account. By the time you need to cash out, it’s worth $300. That’s $200 in gain. Many high-income individuals actually retain roughly 2/3rds of their working incomes in retirement—what this means is that your capital gains might be taxed at upper levels. That might mean that long-term capital gains would be taxed at 20%. On that $200 gain, you’d only get $160 after taxes. If this were in a Roth IRA, you’d get the full $200 gain in your pocket. Twenty percent is nothing to sneeze at, and if tax rates go up, you might end up paying even more in a taxable account.
Naysayers beware
Some people are opposed to the Roth IRA structure because no one can predict the future. The government could change its mind at any time, get rid of the benefits, and start taxing the gains inside the Roth IRA. Many people believe that tax rates could potentially go up, so we stand to lose out even more if our gains are taxed in the future. There are obviously political fears that play in as well–if the government needs to reduce deficits then it could start making these changes.
The only truth about any of these fears is that no one can predict the future.
Yes the government can change whatever it wants with its rules, but there are many logical reasons why the Roth IRA isn’t a huge player in the grand scheme. Firstly, the Roth IRA is a relatively small investment vehicle. One can contribute only $6000 (or $7000 for catch-up age) in 2021, while 401k’s, defined benefit plans, SEP-IRA’s, and profit-sharing plans have contribution limits starting at $58,000 annually. This means that Roth IRAs are poor revenue generators for the government. The national debt isn’t going to improve significantly by eliminating the Roth IRA or taxing its gains, but getting rid of it would anger a whole lot of people. Secondly, the only benefit of a Roth IRA is that any gains in the vehicle are tax-free. Opting to tax those gains would nullify the purpose of its existence. Thirdly, any changes would likely impact new contributions only–it is too complicated to retroactively enforce rule changes from decades ago.
Diversification is the spice of life
Physicians fortunately are positioned to have many options to grow their wealth. And all options should be considered given that no one can predict the future. The Roth IRA is a great investment vehicle even if you have doubts, because the contribution limits are relatively small. There are people who spend more than $6000 a month on VIX plays or Bitcoin.
The only reason why you shouldn’t contribute to a Roth IRA is if you have significant investments in a SEP-IRA or any pre-existing IRA basis. If you make Roth IRA conversions (backdoor approach for high earners), then you will need to pay taxes on the earnings.
If you want to get started with Roth IRAs, head over to learn about the basic Roth IRA steps, and also read our step-by-step guide on contributing to a Roth IRA in E*Trade. If you have a different custodian, the steps are similar. We will post guides for the other investment firms in future posts.
What are your thoughts on the Roth IRA?