What is the future value of your Roth IRA?
Ask most people this question, and they'll break out a financial calculator, type in a bunch of numbers, and spit out a projected dollar figure for some future date.
But that's not really what I'm getting at. Instead, I ask this question in order to challenge you to think about your Roth IRA differently, because it presents you with some unique opportunities relative to traditional retirement accounts.
In order to illustrate, let's review the conventional wisdom of the past several decades in regard to financial planning.
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The Traditional Financial Advice
Over the years, the boilerplate advice from most financial planners goes something like this:
“Year after year, invest 15% of your annual pre-tax income in a retirement account (401k, IRA, Roth IRA, 403b, or other). Then in retirement, make annual systematic withdrawals of 4% to 6%.”
This isn't necessarily bad advice, but is it the best advice? Under such a scenario, your money will last a few decades, and hopefully you won't outlive it.
But what if you took this advice and retired in early 2008 – right before the market tanked?
Even if you invested everything in bonds prior to retirement, are you certain inflation won't prematurely deplete your nest egg?
Maybe it's time to reassess your retirement plan, and a self-directed Roth IRA presents you with a unique opportunity.
Roth IRA vs. 401k & Traditional IRA
A Roth IRA holds two distinct advantages over a 401k or Traditional IRA:
- Qualified withdrawals are tax-free, and
- You aren't forced to ever make a withdrawal
The first difference is self-explanatory, but the latter is often overlooked. With a 401k or Traditional IRA, you're required to start making annual withdrawals at age 70 ½. The amount you're required to withdraw varies depending on your life expectancy.
But what if you don't need to make withdrawals? Or what if you don't need to withdraw as much as the IRS requires?
It doesn't matter. You're still forced to make withdrawals.
In order to determine how much you must withdraw after age 70 ½, divide your account balance as of December 31st of the previous year by the number associated with your age in the IRS Life Expectancy Tables.
For instance, at age 71 that number is 16.3 – which translates into a 6.13% minimum withdrawal.
At age 72, it's 15.5 – which equals a 6.45% minimum withdrawal.
By age 80, you're looking at a number of 10.2, which means a minimum 9.8% withdrawal – regardless of whether or not you need or want to withdraw your money!
These forced withdrawals eat away at your principal, especially if (when) the market experiences a major downturn.
And if you think investing in fixed income investments will protect you from market volatility, know that one trade-off is you won't benefit from the historical inflation-beating returns of the stock market.
At this point, the true value of your Roth IRA becomes apparent. Why? Because it allows you to invest for cash flow instead of asset appreciation.
Cash Flow vs. Asset Appreciation
When it comes time to withdraw your funds, which is a more consistent and reliable source of cash in your pocket – stock prices or dividends?
Looking at the past 40 years of historical S&P 500 returns (1972 to 2011), the index posted an annual return of 11.58% with 25 of those years experiencing a gain of greater than 6%, while 15 were below 6%.
Over the same time period, dividends increased year over year in 37 of the 40 years, posting an average annual increase of 10.89%.
Conventional wisdom advises us to invest for capital appreciation and then sell off our assets in retirement. But why sell off your assets? If you do, eventually you won't have any assets left.
Fortunately, an alternative option does exist. It's called “investing for cash flow”.
Unlike traditional retirement accounts, your Roth IRA allows you to invest solely for cash flow, withdrawing only (if you so choose) the annual cash generated by your dividends. Meanwhile, your principal remains intact, decreasing the likelihood you'll run out of money in retirement. Even if the market declines 40%, shrinking your principal, you're focused on dividends only – and you can withdraw these tax-free! In the meantime, market fluctuations don't matter. Why?
Because if you invest for cash flow, you don't care what the overall market does. What matters is the cash dividend, not the current price of stocks. And dividends are remarkably consistent and resilient from year to year.
Let's take 2009 as an example. That's the most recent of only 3 years in the past 40 in which the dividend payout on the S&P 500 decreased year over year. That year, dividends declined 20% from the previous year. But that stands in stark contrast to a 37% decline for the overall stock index.
So if you had a $1 million retirement account with a 3% dividend yield, you would go from $30,000 per year in dividends to $24,000. But if you relied on stock price appreciation for retirement, your $1 million balance declined to $630,000, and you would have to withdraw a minimum 6.13% from your account. This would deplete your principal by $14,619 (or 2.3%) when accounting for the $24,000 in dividends. And this is under a best case scenario. As you age, your required annual minimum withdrawal will increase in both percentage and dollar terms.
Roth IRA calculators give you one option for projecting the future value of your Roth IRA. But more important than the size of your retirement nest egg when you quit working is how you plan to utilize it.
Instead of selling off your assets during retirement, consider leaving the principal untouched for the rest of your life and living off of the dividends.
Then you can withdraw those dividends tax-free each year while your principal continues to grow (unlike your 401k or Traditional IRA which force you to start making withdrawals at age 70 ½).
Meanwhile, your dividends grow at an annual pace faster than inflation – meaning your standard of living increases and you don't have to worry about outliving your money. And that's the true future value of your Roth IRA!