Published July 12th, 2016
Reducing your investing fees is the best way to generate higher total returns.
Most investors focus on minimizing fees from their brokerage. If you made 4 trades a month (2 buys and 2 sells) over 30 years, that comes to $14,400 at $10 a trade.
If you get serious and shop around for a cheaper brokerage, you could reduce trading costs to $5 a trade (as an example). This would result in savings of $7,200 over the course of your investing career.
That’s sizeable money, but it pales in comparison to the government’s cut.
A $100,000 account returning 9% a year with a 50% turnover rate will incur taxes of $176,272 over 30 years (using a 20% long-term capital gains rate for all gains).
Think about that…
- $14,400 in brokerage fees over 30 years
- $176,272 in taxes over 30 years
Which one do of these categories do you think investors should spend more time on?
My money goes to taxes (pun intended).
This article takes a look at how a Roth IRA can greatly reduce your tax bill – and give you more money in retirement.
Roth IRA Basics
A Roth IRA is a retirement account that allows individuals to set aside after-tax income to compound in a tax-free account.
You put after-tax money into your Roth IRA (called a contribution). You take money out of you Roth IRA without paying additional taxes to fund your retirement (called a distribution).
The basic characteristics of a Roth IRA are discussed below.
- There is an annual contribution limit of $5,500 ($6,500 if over 50) or your annual income, whichever is lower
- Full contributions for those who are married filing jointly are only allowed if your adjusted gross income is less than or equal to $184,000.
- Full contributions for single tax payers are only allowed if your adjusted gross income is less than or equal to $117,000.
Failing to meet the following distribution rules will result in paying a penalty tax (in most cases) of 10%. A list of qualified exceptions to the tax penalty can be found here (under ‘Exceptions’).
- Distribution must be made after the 5 year period beginning with the first tax year you contributed to the Roth IRA to avoid penalties
- Distributions can only be made on or after you turn 59 ½ to avoid penalties
Source: Roth IRAs from the IRS
The Advantage of Dividend Stocks in a Roth IRA
The advantage of a Roth IRA is that it allows your investments to grow tax free.
In effect, you pay your taxes before your investments compound, instead of after.
In normal accounts (non-retirement accounts), qualified dividends are taxed at the long-term capital gains rate of 20%. Non-qualified dividends are taxed at 39.6% (both numbers are for the highest income tax bracket).
Instead of paying taxes on these dividends every year, dividend payments are left in the Roth IRA. They can (and should be) reinvested either into the stock that payed them (called DRIPing) or into other high quality dividend growth stocks.
Over time, these tax savings can add up to thousands of dollars…
The image below shows the account value of $10,000 invested in a stock that grows at 6% a year and pays a 3% a year dividend (dividends are reinvested). A 20% dividend tax rate is assumed.
- Roth IRA balance after 20 years of $56,044
- Regular account balance after 20 years $50,186
I’d rather have that extra $5,858 after 20 years (for no extra work).
Remember, dividend income in a Roth IRA is not taxed. It does not count toward your annual contribution to the Roth IRA, either.
Avoiding dividend taxes is a plus in a Roth IRA, there’s no question about it.
Roth IRAs can save significantly more money by eliminating capital gains tax every year. The higher your portfolios turnover rate (and gains), the greater the tax savings from the Roth IRA versus a normal (non-retirement) account will be.
Required Minimum Distributions in A Roth IRA
401Ks and Traditional IRAs have something called a ‘required minimum distribution’. You are forced to take a certain amount of money out of your retirement account every year after you turn 70 ½.
Roth IRAs do not have required minimum distributions.
This gives them greater flexibility. Your money is free to compound in a Roth IRA as long as you are alive. Required minimum distributions do not start until after you pass away and your beneficiary gets the Roth IRA.
No required minimum distributions means a longer compounding window; more time to grow your dividend snowball.
Build Your Dividend Growth Portfolio In A Roth IRA
If the ultimate goal of your portfolio is to fund your retirement, then a Roth IRA is a good choice.
The tax advantages of a Roth IRA allow you to benefit from the power of compounding without giving Uncle Sam his ‘fair share’.
Do not fall into the trap of trying to maximize your tax savings at the expense of maximizing your total returns in a Roth IRA. What does this mean?
It means don’t invest in ultra-high dividend yielding stocks (which carry too much risk) to try to wring every last ounce of tax savings out of the account.
Instead, invest in high quality dividend growth stocks with favorable total return prospects. The 8 Rules of Dividend Investing will help in:
- Finding high quality dividend growth stocks
- Determining when to buy
- Determining when to sell
How to Open a Roth IRA
Roth IRAs can be opened by individuals at many well-known brokerages.
A brief list of well-known brokerages that offer Roth IRAs is below. Brokerages are sorted in order based on transaction cost.
- TradeKing – $4.95 per trade
- Merrill Edge – $6.95 per trade
- Scottrade – $7.00 per trade
- Vanguard – $7.00 per trade
- Fidelity – $7.95 per trade
- ETrade – $9.99 per trade
- TD Ameritrade – $9.99 per trade
Fees matter in investing. The less you pay the government (by using a retirement account like a Roth IRA), and the less you pay your brokerage (by minimizing transactions and transaction costs), the more money is left in your account to compound – where it belongs.