Are You Applying the Best IRA Strategy?

Posted on Posted in Investing, Retirement

Are you making your money work as hard for you as you do for it? Are your retirement accounts growing like they should be? If you’re not using the best IRA strategy, then you’re likely leaving A LOT of money on the table.

Are You Applying the Best IRA Strategy

Here’s a big tip I think you’ll like!

IRAs are a great tool to save for retirement, but few of us are applying the best strategy to make the most of our accounts. Let me explain.

In order to implement the best IRA strategy, we must understand (1) the primary differences between Roth and Traditional IRAs, (2) the potential returns of different asset classes we can use, and (3) how to implement the strategy into our portfolio. Once we understand these three factors, we can generate hundreds of thousands of extra dollars within our portfolios.

The Difference Between Roth and Traditional IRAs

There are several differences between Roth and Traditional IRAs, but for the purpose of this article, I want to focus on the primary difference—the tax treatment.

Understanding how to exploit the tax advantages of IRAs within your investment strategy can lead to hundreds of thousands of extra dollars for you and your family.

Roth IRA

With a Roth IRA, you pay taxes on the money you contribute up front, but all the compound growth is tax free. For example, if you contribute $5,000 today and it turns into $50,000, you never have to pay taxes on the $45,000 gain as long as you don’t pull the money out early. With Roth IRAs investment returns are tax free.

Traditional IRA

With a Traditional IRA, you don’t pay taxes on the money you contribute today, but you’ll have to pay taxes on it and all the compound growth later when you withdraw the funds. For example, let’s say you contribute $5,000 into a Traditional IRA and in 30 years your $5,000 grows to $50,000. With the Traditional IRA you get to reduce your taxable income by the $5,000 when you originally contributed the money, but you’ll have to pay taxes on that and the $45,000 gain when you withdraw the funds. Traditional IRAs reduce your current tax liability while offering an investment vehicle to save for retirement.

Now many of us understand this difference, but we fail to take advantage of it. I’ll show you how, but first we must look at how different asset classes produce different investment returns.

Understanding the Returns Of Different Asset Classes

The second step to applying the best IRA strategy is to understand the potential returns of the different asset classes we can invest in.

When it comes to IRAs, there are generally two major asset classes to choose between—stocks and bonds. Yes, each of these asset classes can be broken down into sub categories (growth, value, small cap, international, long-term, etc.), but for the purpose this discussion, we’ll keep it at this level.

If you own stock, you own a piece of a company. If you own a bond, you’ve lent money to a company or government. Stocks are perceived to be more risky since they’re more volatile, which means they have greater up and down swings. Bonds are thought to be more conservative since their prices haven’t been as volatile. 

Generally, when it comes to investing, you have to accept a higher risk to generate a greater reward. This is true with stocks and bonds so long as we measure risk through volatility.

For about the last 30 years, the total bond market has generated about 5-6% per year while stocks have produced about 10%. That may not seem significant, but it’s huge.

Check this out.

If you would have invested $50,000 in bonds 30 years ago and earned an average of 6% per your, you would have about $290,000 today. If however, you would have invested $50,000 in stocks and earned a 10% return per year, you would have close to $875,00 or nearly 3 times more than you would have with bonds!

 

 

Now this is not at all to say that stocks are better than bonds. Rather the purpose is to show you that different asset classes generate different returns and serve different purposes.

With a long time horizon, stocks, the “riskier” investment, can generate significantly more wealth than bonds. But with a short time horizon, bonds may be best option since they’re less volatile. Either way, generally the best strategies include a mix of both assets, so investors can grow and preserve their wealth. The amount of each asset depends entirely on the investor—their goals, risk tolerance, time horizon, and ability to absorb market fluctuations.

How To Apply the Best IRA Strategy

So how does all this impact your IRA strategy? Let’s dig in.

Make sure to keep in mind: (1) stocks are more risky but have generated significantly stronger returns over the long haul, and (2) you don’t have to pay any taxes on investment growth with a Roth IRA.

You may see where I’m going here.

So with that in mind and the fact that you’ll want to invest in some bonds and some stocks, here’s what you do.

Impact of Stocks Versus Bonds

The first priority for your Roth IRA should be stocks and other high-growth investments. You want investments that will generate high returns since you don’t have to pay taxes on the increase. It’s all about generating as much after tax wealth as possible.

Remember the example from above. Bonds generated returns of $240,000 while stocks generated $825,000 of compound growth. That’s a difference of $585,000, which means you would have $585,000 more tax free wealth if you would have prioritized stocks over bonds in your Roth IRA.

Now of course you’ll still want to invest in bonds—you must to keep your portfolio consistent with your asset allocation targets. But where you choose to invest with bonds doesn’t matter as much.

In order to bring your portfolio into balance with your asset allocation targets, you’ll be able to buy bonds in your company’s 401(k) plan, a Traditional IRA, or a taxable brokerage account. If you’re only saving enough to use a Roth IRA, then it’s perfectly fine to buy bonds within this account; however, it’s not as high of a priority—you want your Roth to be filled with as much stocks as your asset allocation targets suggest.

Prioritizing your funds this way can save you hundreds of thousands of dollars in the long run.

Impact of Roth Versus Traditional

Using the example from above, let’s say you invested in 100% stocks and amassed $875,000. With a Roth IRA, that $875,000 is yours to keep. But with a Traditional you could end up paying over $200,000 in taxes as you withdraw your funds (the amounts depends on your tax rate & tax strategy).

Note: There are strategies you can apply to reduce your tax liability as you withdraw your Traditional IRA funds, but those strategies will have to be discussed on a later post.

By no means is the purpose of this example to show that Roth IRAs are more superior than Traditional IRAs—each account has it’s pros, cons, and limitations. For more around that discussion check out How To Set Up Your Own IRA.

Rather the point of this example is to drive home the argument that Roth IRAs have a great ability to provide a significant amount of tax free wealth so long as you prioritize the right investments—ones that will significantly compound and grow over time.

So just to be clear, the first priority for your Roth IRA should be stocks and other high-growth investments. Your Traditional IRA is perfectly fine for your more conservative investments like bonds since you’ll be paying taxes on all the growth later.

Here’s How It Works

The goal should generally be to fill your Roth IRA with stocks and use other investment vehicles (Traditional IRA, 401k, etc.) to bring your portfolio into balance with your allocation targets.

Let’s use an example just so we understand exactly how it should work. For simplicity, we’ll exclude the possibility of a company sponsored 401(k) plan and Health Savings Account.

Let’s say you want to invest $10,000 a year and your target asset allocation is 10% bonds, 90% stocks.

As of 2017, the maximum you can contribute to an IRA is $5,500, so you won’t be able to put the entire amount into an IRA unless you’re married. Married couples can stock $11,000 into IRAs ($5,500 each) as long as they’re under 50. Those who are 50 and older can contribute an additional $1,000 per year. 

With that said, here’s how you should prioritize the $10,000 if you find a Roth IRA to be more advantageous for you:

  1. Roth IRA: $5,500 should be invested in stocks using low-cost index funds such as VTSMX and MGTSX
  2. Spousal IRA (Roth) or Taxable Brokerage Account if you’re single: $3,500 should be invested in stocks using low-cost index funds such as VTSMX, VFINX, MGTSX
  3. Spousal IRA (Roth/Traditional/Combo) or Taxable Brokerage Account if you’re single $1,000 should be invested in a bond based index fund such as VBMFX

Here’s how you should prioritize the funds if you find a Traditional IRA to be more advantageous:

  1. Traditional IRA: $4,500 should be invested in stocks using low-cost index funds such as VTSMX, VFINX, MGTSX
  2. Traditional IRA: $1,000 should be invested in a bond based index fund such as VBMFX
  3. Spousal IRA (Roth/Traditional/Combo) or Taxable Brokerage Account: $3,500 should be invested in stocks using low-cost index funds such as VTSMX and MGTSX

It doesn’t matter whether you find a Roth or a Traditional IRA more advantageous, the priority of funding is the same. Stocks are allocated to Roth accounts and bonds are sent to traditional or tax deferred accounts. A Roth IRAs first priority should be high-growth stock funds.

Check out How To Set Up Your Own IRA to determine whether a Roth or Traditional IRA is better for your strategy.

Conclusion – The Best IRA Strategy

Most folks are missing out on thousands or even hundreds of thousands of dollars because they aren’t prioritizing their investments appropriately within their retirement accounts.

Roth IRAs have a unique ability to provide a significant amount of tax free wealth so long as you prioritize the right investments. You want to give priority to the asset classes that will significantly compound and grow over time. That’s normally best achieved by investing in stocks using low-cost index funds.

Action Steps

Make stocks the first priority of your Roth IRA as doing so will give you the best chance at accumulating the most after tax wealth.

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2 thoughts on “Are You Applying the Best IRA Strategy?

  1. I generally like what I’m reading on your site, but your advice on allocating $10,000 a year split between the two types of IRAs seems flawed. As far as I know, you are capped at $5,500 per year into ANY IRA (assuming you’re under age 50). That means total for a Roth and Traditional combined. I’d love it if in wrong and am missing something but I don’t see how an individual can invest $10k a year in IRAs. As a couple, it works, but then you would do two Roth IRAs, one for each person. No need to put any in a traditional. Can you please explain? Thanks!

    1. Kap, thanks for reading and commenting! You’re right. The max an individual can contribute per year is $5,500 a year unless they’re eligible for catch up contributions, which, like you said, means the individual is 50 or older. A couple can contribute up to $11,000 together whether both spouses have earned income or not (spousal IRA). My example was poorly worded and not explicit enough. I called out the max an individual can contribute then showed the example for a couple. Thanks for catching that! Hopefully the updated version better serves readers. Hope to see you around the site!

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