What could be more futile than socking away $5000/year for 40 years, hoping for a secure retirement? But this is exactly the "promise" of the traditional and Roth IRAs. That's a mere $200,000. You can barely buy a decent house for that, let alone pay for your hundreds of thousands of dollars in drugs and surgeries as a senior.
"But", you protest, "it's more than that! The contribution limits grow every year!"
Yes, they do. And essentially, over the longterm, they grow with inflation. So $200,000 is measured in 2009 dollars. My analysis doesn't change because, approximately, the price of everything rises at the rate of inflation over the longterm. So while your traditional IRA contributions might total $2,000,000 after accounting for inflation, they still won't buy you much more than a house in 2049.
If you're depressed by now, then you know how I felt as I wrote my first traditional IRA check: totally futile. "This isn't even worth the effort to manage the account. It takes around $2,000,000 per person to retire at age 30 today -- very modestly -- nevermind deacdes from now! How will this lame car drive me where I want to go?"
What I didn't realize at the time was that (1) it matters which assets one purchases in the IRA, (2) the traditional IRA represents a tiny fraction of what you can actually contribute annually to tax-deferred accounts, and (3) most IRAs aren't merely tax-deferred; if you play your cards right, they're nearly taxfree!
Unappreciated Advantages to IRAs
1. Let's talk about assets. The easiest thing to do is visit the Risk and Return Calculator for IFA Indexes, which measures the performance of major investment indices over several decades, with reasonable accuracy. As you can see in this simulation of IFA US Large Company Index returns for the past 40 years, an investment in this index would have yielded an annual return of about 8.62%. But an investment in the IFA Emerging Markets Index would have yielded 15.94%! The second case returned $36,953 in 40 years -- from a one-dollar investment in 1969! The large company index, meanwhile, would still have returned a staggering $2631 in the same time period. Inflation tends to run about 4.5% over long periods of time; over 40 years, this would create prices 5.81X as high for the same products and services. So, after adjusting for inflation, the returns would have been $6360 and $547, in 1969 dollars. Still, this is an incredible fortune, relative to $1 invested. What's even more striking is how much the asset class matters. Just for the sake of tolerating some larger temporary losses, emerging markets would have paid vastly more money. The power of exponents, and particularly large exponents versus small ones, can hardly be overstated. As Einstein once put it, the most powerful force in the universe is compound interest. Especially, I might add, when it comes with little or no tax liability!
2. The traditional IRA is sufficiently famous that you may be ignoring just how much cash you can sock away, to grow tax-deferred until withdrawal. (Even then, you may pay little or no tax, as you'll see later.) Let's look at 2009, for instance. Most people can contribute $5000, in total, to traditional and Roth IRAs. (Some people aren't elligible to contribute to a Roth, as their income is too high.)
Don't forget that you could also contribute $16,500 to a 401(k), which expands that $5000 to $21,500! This benefit alone may justify switching jobs if your current employer has no such program (but you might not need to, as I'll explain below). This also ignores popular employer matching programs, in which employers sometimes match a portion of employee contribution. Now this is becoming a bit more interesting. You'll therefore have $860,000 2009 dollars to retire on in 40 years, assuming a 0% return after inflation, i.e. a 4.5% annual return. Even with the horrendous cost of medical care, that amount might last you 5 or 10 years. But if you invest more aggressively (without taking undue risk), you're likely to end up with vastly more by maxing out both your 401(k) and traditional/Roth IRA every year.
However, $16,500 is just the 2009 limit for employee 401(k)s. If you can manage to earn some income as a self-employed individual, you can contribute up to $49,000 to your 401(k) this year! (See Fidelity's article on the self-employed 401(k).) This includes any contributions you make as an employee, and any employer matches. Granted, in order to do so, you need to earn roughly a quarter million bucks per year. But the contribution ceiling scales with income, such that it may be in your interest to take a side job, or negotiate self-employment status with your current employer, in order to take advantage of this fantastic tax loophole. (Just remember that you may lose other benefits in the process.) So in total, we have $54,000 in tax-deferred income available, if only you can earn enough.
If you're like me, and you hardly earn enough money to eat because you write blogs all day, then this $54,000 is not currently relevant. However, it may be useful for you to get working on a strategy for keeping your current job, while changing your tax status to self-employed, in order to take advantage. In the longterm, when your earnings inevitably rise, you will have the system working for you already. Most importantly, you will have developed the habit of deferring major chunks of income to your retirement account.
3. If this were not enough reason to open a self-employed 401(k), then perhaps this will motivate you: the income, upon withdrawal, may be nearly or exactly taxfree. "But how can this be?" you ask. "My investment advisor always told me that that traditional IRAs and 401(k)'s are taxed upon withdrawal."
Well, technically, they are, but at what rate? One obvious way to reduce the tax rate is simply to withdraw less: retire below the poverty line, and you'll pay little tax. But then you might as well through your IRA in the river, and pay no tax at all.
Alternatively, there is a little-known trick to obtaining taxfree withdrawals -- even from a traditional IRA! It's called "annuitization". Annuitization basically entails the creation of a withdrawal policy designed to make the withdrawals last for life. The IRS is very murky about what constitutes a sustainable lifelong withdrawal policy, because, after all, future returns are uncertain. It can even involve complex computer simulations known as "monte carlo analysis". So I'll leave you to discuss this route with your tax accountant. Frankly, I do not advocate annuitization. Why? Because if you want to retire before your golden years, you should do so using a taxable brokerage account, real estate, or a business to support yourself. You should not sacrifice taxfree growth by withdrawing early from your IRAs. So, I have a better suggestion for accessing the income in a tax-minimized manner upon withdrawal.
You see, there's a handy little tax manoeuver called a Roth conversion. It allows you to convert all or part of your traditional IRA into a Roth IRA. (Since a 401(k) can be rolled into an IRA with zero tax consequences, it can be converted from there to a Roth, although I have not researched the prospect of direct conversion. Only one conversion is allowed per year, probably because the IRS computer systems were not designed to handle more.) Though there are several trivial differences, traditional and Roth IRAs are essentially identical, except that the former generally offers tax deductions upfront, in exchange for taxed distributions upon withdrawal; whereas the latter offers no such deductions upfront, in exchange for taxfree withdrawal after age 59 1/2. (401(k)'s behave, in this sense, like traditional IRAs.)
Of course, the IRS never offers a free lunch, so you need to pay ordinary income taxes on the amount you convert in a given year. For example, if you convert $10,000, then you've just earned $10,000, which is then added to your taxable income. But here's where the art of tax avoidance (as opposed to tax evasion) comes in! Depending on your age, you may have decades to accomplish the conversion. So, little by little, you move money from your traditional to your Roth. Only do this in years when your income is low, or better, you're unemployed and have no income at all. This will minimize the overall tax rate you pay to complete the conversion. If you have shares in a business partnership (for example, real estate, or a grocery store), you can convert more in years that you have large flowthrough losses, which will kill the income from the Roth conversion for tax purposes. Just be aware that the longer you wait, the larger your traditional IRA balance will tend to become, eventually outstripping the rate at which you can convert it in a tax-minimal manner.
Granted, if your income exceeds certain limits, then you're not allowed to contribute to a Roth at all, even through conversion. However, the deductions from a traditional IRA and a self-employed 401(k), and a business with passthrough losses, will help you stay under those limits. (And frankly, if you exceed them, then your tax bracket for the year is sufficiently high that it's not to your advantage to do the conversion anyway. So convert little by little, when the opportunity arises. You can wait until December, when you have a better idea of your likely tax bracket.
Eventually, you'll have most or all of your IRA assets in your Roth, which you can then withdraw taxfree after age 59 1/2.
I will describe this process in more detail in my next post, The Art of the Roth Conversion.
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