One Downside of a Roth IRA

I’m starting with a disclaimer here.  We could debate for hours the pros and cons of a Roth IRA; Heck, Lanny has written about both sides of the Roth vs. Traditional argument already…first about maximizing your Roth IRA contributions for 10 years and then writing about his plan to use a Traditional IRA going forward during the summer.  What am I proving here?  There is not a one size fits all approach and using a Roth or a Traditional account may (and should) change as your financial situation changes.   This last week I experienced one of the downsides of a Roth IRA and I wanted to share it with all of you.

Roth IRA

Today, my beef is with the $5,500 annual contribution limit.  As we all know, the IRS restricts the annual contribution for a Roth IRA or Traditional account to $5,500 if your annual income exceeds this amount.  Earlier in my investing career, I typically would wait until the beginning of the next year to maximize my Roth contribution for the prior year.  Thus, all my investments from January through the deadline were related to prior year contributions.  Since my goal is to maximize my Roth IRA annually, I started to dislike this approach because it would force me to buy lower yielding dividend stocks (such as Schlumberger) in my Roth IRA versus regular account just so I could satisfy my desire to maximize my Roth IRA.   My goal in maximizing the Roth was to gain the most benefit of tax-free growth and here I was wasting this valuable benefit on lower yielding dividend stocks because I did not plan ahead.  Starting in 2015, I made it a goal to maximize my Roth IRA contribution before the end of the year so I could plan on purchasing most of my high yielding investments and REITs in this account.

The last stock I purchased was Realty Income.  I added 40 shares to my Roth IRA a few weeks ago and the approximately $2,300 purchase was the exact dollar amount left in my annual $5,500 limit.  I was pumped and thrilled that I was able to stick to my goal and maximize my Roth IRA contribution.   Then what happened?  You guessed it….the stock price dropped 10%.  Even Lanny was calling me out in his October dividend income article about the fact I had not added to my position in the beloved REIT.  Well, there was a sad, legal reason why I couldn’t just transfer money and purchase more shares.  That’s because I hit my maximum limit and was prohibited from transferring funds into the account.  UGH!   My options were to purchase Realty Income in a regular brokerage account and accept the tax disadvantages or sell a stock and use the proceeds to purchase additional shares.  I had a few contenders for stocks I would potentially sell, but I wasn’t ready to make that decision at the time.  So you guessed it, my action for the week was no action.  I will not be adding to my position most likely until January 1, 2017 at the earliest.

What’s my takeaway from this experience?  I’m always trying to find a takeaway when situations like these, especially as I am getting ready to set my 2017 goals.  The IRS gives you almost four extra months to contribute to the previous year’s IRA limit, so why I am I trying to contribute the maximum amount within 12 months and potentially change my investment strategy artificially?  If I weren’t so adamant about purchasing stock in my Roth and maxing it out before December 31, maybe I would have had between $3,000 and $3,500 to invest in Realty Income, a company that should be held in my Roth, versus only $2,300.   Why was I so eager to knock this out-of-the-way?  That’s a rhetorical question of course, but going forward, I am going to be more careful about which company’s I buy in my Roth IRA versus regular account so that I have the tools available to me when I want to make a splash.

What are your thoughts on this situation?  Has you run into this issue before?  How do you manage your Roth IRA investment decisions?  Do you only purchase certain stocks in your Roth IRA because of the tax benefits?

-Bert

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21 thoughts on “One Downside of a Roth IRA

  1. Hi Bert,
    While I have never experienced the pro’s and con’s of a Roth IRA I subscribe to the idea that doing or not doing something simply because of tax considerations is not a good reason. I had a tax efficient savings account for a while but then the tax law changed and my bank sort of stopped servicing the product as a consequence. If you think that you should add to Realty Income, you should do it regardless of in which account. The matter of how to fund trades is always tricky. I think if I knew I want to contribute fresh cash to my portfolio next month, I think I would borrow for a little while to be able to buy now.

    • DIB,

      I agree with the premise of your comment. A tax benefit should not drive your final decision and in this case, it didn’t. I had already determined that I was going to purchase Realty Income. The only thing left to decide was if I was going to purchase Realty Income in my Roth IRA or traditional account. This is where the debate about the tax benefits came into play and I think you should absolutely consider the tax benefits when deciding where to purchase the investment.

      I’ve been trying to think this without finding a way to sound contradictory in my response to your comment. I had already decided my next purchase was Realty Income and I had two different purchase prices in mind based on which account I was purchasing the company in. At my purchase price, I do not think I would have purchased Realty Income in my regular account because of the tax implications. Does that make sense?

      Bert

  2. My thoughts are if you’re comfortable purchasing the shares because you see good long term value then it’s just water under the bridge. I’ve been in situations where I’ve purchased shares, the share price continued lower another 5% and I wanted to buy more but had no capital available.

    Since tax advantaged accounts have the issue you’ve run into with the contribution limit, I think the key is to just stick with companies that you have a high degree of confidence will continue to be doing well 5-10 years down the line. Once it gets to a price that you’re comfortable paying then whatever happens happens. The contribution limit is burdensome in this situation but regarding O and other REITs it might do you some good to have to wait until January to start contributing again because the share price could very well move even lower given the chances of an interest rate hike.

    • JC,

      Thanks for the comment. You first sentence is my typical viewpoint. I would have loved to add more CAH when the stock price tanked; however, the funds just weren’t there. Was I pissed…for a minute, but then I had to move on and keep on plotting for my next investment decision.

      That’s a great way to think about tax advantage accounts, especially considering how long you must keep capital in an IRA without incurring a penalty. In 5-10 years, I won’t remember that the stock dropped 5% for the first week after my initial purchase. Hopefully I’ll be starting at some large gains.

      Hopefully you are right and if you are, I will be pouring some capital into Realty Income come January!

      Bert

  3. If you have any stocks or funds that are less of a tax liability than REITs and want to add more REITs – you could always sell those stocks in the Roth(not a taxable event) and buy them in your taxable account immediately freeing up the money needed for the REIT in that account.

  4. I wouldnt worry about it too much. This is how I actually address the available contribution in a ROTH IRA. You can transfer your normal brokerage stocks (usually called “contribution in kind”) to the Roth anytime within the year as long as the value of the stock/s is about $5500.

    For an example, if you feel Realty income is dirt cheap and value, you can purchase it anytime in your brokerage account.

    Come next year, when you have the contribution room of an additional 5.5K, you can transfer those shares over.

    Any foreign income, reit income should be in your ROTH. (since these are 100% taxable vs a dividend income where it is like 80% taxable)

    For example, I have Shell (Europe/Netherlands) shares in Roth – and they are paying an insane 6-7% of dividend yield.

    • Sorry but this is wrong, the IRS only allows cash contributions to Roth and traditional IRA’s! There is not a contribution in kind option. You can transfer assists in kind from IRA’s to Roth’s as part of a conversion however.

  5. Always buy higher yielding assets in the tax deferred accounts and you avoid taxes, at least until their taken out of a traditional IRA! I don’t get your point about being forced to buy lower dividend stocks in January, this just isn’t the case! What time of year you make contributions has nothing to do with what you buy or when! You don’t seem to have a grasp of the whole Roth vs Tradional IRA? The annual limits are the same and increase to $6,500 over age 50.

    • Thanks Mart! I should have given more backgorund about why I purchased SLB in a Roth vs regular account because of the lower yield. I purchased SLB in January 2015. At that time, I had contributed $0 towards my Roth IRA. In order for me to maximize my benefit for 2014, the first $5,500 of purchases in 2015 had to be in my Roth so I could reach this limit. Does that make sense? If I had maximized my 2014 Roth contribution in 2014, then I would not have been forced to make this purchase in the account I did and I would have absolutely purchased the stock in my regular brokerage account.

      Bert

  6. The contribution limit is definitely a downside, and I’m right there with you in waiting until January 2 when I can buy more O (and HCN). However, I still think it’s better to max out contributions in the Roth IRA as soon in the year as possible. I don’t know how the share prices will change throughout the year – but by investing the whole $5500 in January, I have dividends from the new shares adding to my account for the remainder of the year.

    • Looks like we are both in the same investment line. Hopefully my price will be slightly lower on January 2nd haha That thought process is exactly why I set my goal as it was. I wanted to hit the maximum as early as possible. The situation I ran into is the one con to that plan; however, if you think the pros of investing early outweighs the con of hitting your limit and missing out on an investment like realty Income, then all of this is a moot point!

      Bert

  7. Frustrating early on in the Roth IRA contribution process, but as the balance and dividends grow, this is a lessened worry.

    This is why I personally do not reinvest my dividends. I contribute to the Roth throughout the year rather than in a chunk, mostly for this reason. I’m at about 150-200/month in dividends in my Roth. If I do 500/month contributions, plus the 450-600 dollars in dividends, I’m ready for a purchase!

    As this account grows, obviously the dividends will be more self-sustainable to provide money for further purchases. I was hoping the limit was finally going to head to $6,000 this year, but I guess not. It’s been since 2013!

    • Stacker,

      Interesting take on deciding to not re-invest dividends. I’ll consider this options when my quarterly dividend income within my Roth is sufficient enough to make a substantial purchase. Right now, I don’t know if my income is high enough where the trade fees outweighs the benefits. But with that being said, I guess I could always add the DRIP to the new stock I purchase with funds transferred in. Very cool idea!

      Bert

      • I believe it was Dividend Mantra a while back who convinced me not to DRIP dividends. I could have that wrong though.

        But yea, essentially your capital pool grows quicker without reinvesting dividends. And then you have the ability to choose where your new funds go (rather than potentially DRIPping a stock at an all-time high), more quickly without the dividends.

        You’re going to be buying a new security anyway right? So that trading fee is actually already out the window, if you really think about it. It just gets you to your capital requirements faster.

        • Ah yes! I put some thought into this yesterday after reading your comment initially. If I turned off DRIP in my Roth, I would have $350 in extra cash to add to a purchase quarterly. Now, am I sacrificing some yeid? Yes, considering some of the stocks (FE, BP, GSK) have higher yields than the companies I would potentially purchase. So there is that element that I would consider. Maybe I’ll turn off DRIP when the figure gets closer to $500. You’re right, I’m incurring the fee whether I add the dividend figures or not.

  8. I’m wondering why not contribute to a Traditional IRA while you’re in a higher tax bracket? In other words, why are you paying higher taxes on that $5500 just to contribute to a ROTH IRA?

    For many years I was contributing to a ROTH then I was like, “Whoa!!??” What am I doing? Now, I’ve been contributing to a Traditional IRA while I’m in that higher tax bracket.

    • Raymond,

      I’m going to lump that into the “other downsides of a Roth IRA versus Traditional” bucket that I mentioned at the beginning of the article. My wife is going to be changing her career soon, which should increase her earning power. So I need to crunch numbers and see if it is worth the headache of switching to a Traditional for a short period of time. But yes, that is a very fair point!

      Bert

  9. Hi Bert,
    The limits are frustrating – I can’t even contribute to my Roth any more because of income limits, so I’d be happy to have the contributions limits to worry about 🙂 It’s a shame as I like the flexibility and no taxes feature of the Roth so I’m planning to spend my 401k first in retirement before even touching the Roth.

    I guess I don’t understand why you were forced to “buy lower yielding dividend stocks (such as Schlumberger) in my Roth IRA versus regular account just so I could satisfy my desire to maximize my Roth IRA”. Couldn’t you buy any stock you wanted with your Roth IRA cash contribution?

    Being frustrated about a 10% price drop after a purchase isn’t really the fault of the Roth though – it’d be the same even in a taxable account if you didn’t have any spare cash after the purchase, wouldn’t it? You can a) direct dividends to cash and use that to make new purchases as the comments above suggest, or b) keep some cash in the Roth for special market timing events. I would stay away from the market timing though!

    I think REIT dividends are taxed higher (as ordinary dividends, not qualified). So had you bought them in taxable, you’d be taking an extra hit on the income that would show up at tax time. You’re likely still ahead even had you bought them 10% cheaper in taxable, especially when you compound that tax for the next 30 years.

    Best wishes,
    -DL

    • DL,

      haha fair point! I guess I can’t complain too much considering I can still contribute and achieve the tax benefits. I guess this is a reminder to me that I need to maximize my Roth IRA, tax advantage of the annual contribution limit, before that rug is pulled out from me completely.

      I did a terrible job explaining my Schlumberger purchase. Who would have guessed that a few words couldn’t explain a full backstory. Here we go, here is best best attempt to explain it shortly. I purchased SLB in January 2015. At the time of the purchase, I had contributed $0 to my Roth IRA and I was determined to max it out. At the time, it was highly unlikely that I would invest more that $5,500 before the end of the period that I could allocate 2015 purchases to my 2014 Roth IRA limit. So, all purchases I made in the year had to be purchased in my Roth IRA regardless of yield if I wanted to max out my 2014 contribution limit. At the time of the purchase, I liked SLB as a dividend stock and wanted to purchase it. Therefore, if I wanted to purchased SLB at the time and maximize my Roth contribution, the purchase had to be made in my Roth. In hindsight, I should have included this story in the article to avoid your confusion haha

      You’re right, it isn’t the Roth’s fault the stock price fell. MY frustration is that I could not purchase more shares because of the contribution limit. I liked O at the price I purchased it, so I’m not even mad at the fact I purchased the stock when I did. I never really considered option B, but that is a good idea as well. I looked into turning off DRIP in my Roth and that would net me about $350 in cash quarterly. I don’t know if that is enough to move the needle and make an impact with my purchase.

      Thanks for the comment DL!

      Bert

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