What Roth IRA Fund Should I Invest In?

[SoCal Spartan]

Hey everyone,

I'm planning on opening a Roth IRA soon. Problem is, when I was going through the process on Vanguard's website, I got to the step where you choose which fund you would like and had no idea what I was looking at.

I'm 27, will be starting from scratch (or the $1000-$3000 minimum, depending on the fund) and will be maxing out contributions annually. Running the numbers, if all goes well I am hoping to be FI by 50 (not just from this Roth IRA, of course).

Should I choose the Target Retirement Fund that would end around that time (2035) or do I have better options with other funds?

This may be too broad of a question or more info might be necessary on my end, so please let me know if I can add anything that would be of help.

Thanks!

[beltim]

The best answer will depend on your risk tolerance, but in general a target date fund with the date that you expect to retire is a good choice.  In fact, it's one of the few choices that 401(k) programs are allowed to select as a default. 

With early retirement, it might be better to select a target date fund somewhat later than your expected retirement since you're likely to have a longer retirement.  On the other hand, if you are sufficiently well capitalized going into retirement, you might be able to carry a safer fund.  Finally, the date can be adjusted to your risk preferences - if market downswings will make you sell, it may be better to invest in an earlier target date fund because that would carry a higher percentage of bonds.

[madage]

What works for me is to consider all my invested assets and what I want my overall allocation to be. I then select the lowest-cost funds I can in my 401(k) and use my Roth to "fill in the gaps". Since you're starting from scratch, you can do a lot worse than selecting either the Star fund (essentially a 60/40 split with $1,000 minimum) or one of the Target Retirement funds. The most important thing is to get the money invested and let it grow.

[SoCal Spartan]

Thanks for the recommendations beltim & madge!

One other question: I'm thinking of rolling over an existing 401k from my previous employer (about $2500) into the Roth IRA. The 401k is with Fidelity and I will be opening the Roth IRA with Vanguard.

What is the best way to make the conversion? Should I first rollover the 401k into a traditional IRA, then into a Roth? Or would I better off opening the Roth with my own funds and rollover my previous 401k into my current employer's 401k?

Thanks!

[matchewed]

You'd have to pay income taxes on any tax deferred to Roth conversion. Probably not the wisest move to do if you don't have to at this time. I'd just roll it to an IRA and leave it there. You may collect more 401k's or other employer sponsored plan in the future that you'll need to roll over.

[Stache In Training]

SoCal Spartan,
I believe that target date funds are great, so that you never have to worry about your retirement funds, just set auto contributions and forget.  Gives you freedom to focus on your other investments to make FI.  Some people don't like them since it's less customization, or gets too conservative too fast.  However, I feel you can customize your taxed/early retirement funds.  Also, just mess with the target date in order to choose when to get conservative, as was already suggested.

So for rolling over your 401k, I'm actually in the process of doing that now.  Take advantage of Vanguard's concierge service.  They'll make sure that everything is being set up correctly, and even conference call the other institution (fidelity in your case).  Very nice service.  As for what to roll over to, I am with you.  Since the money is not much, and I can afford the taxes on $2,500, I'd rather roll it over to a roth and pay the taxes now, than pay the taxes that that amount would become upon retirement.  You'll get a lot of arguments, as people will say "but your tax rate will be lower in retirement."  Well there's no guarantee if you have a lot of investments and are just raking in the passive income by that point.  So if you can afford the taxes now, that's what I would do/am doing.  Not saying the other side doesn't bring up good points too, so I think in the end it's personal preference: taxes on 2,500 now, or taxes on 250,000 much later.  At our age, I choose now.

Vanguard informed me that the best way to do the conversion, is to roll it over to a traditional IRA first, and then do a roth conversion.  Apparently (and you'll see this to be true when working on the transfer paperwork) it's an easier paper trail for the feds to follow, and therefore less chances of being audited and so forth.

Hope this helps get you closer!

[matchewed]

I do agree that it's a pay me now or pay me later scenario but I think you're slightly mis-characterizing it by stating -

taxes on 2,500 now, or taxes on 250,000 much later.  At our age, I choose now.

It's taxes on 2500 at your current tax rate or taxes on whatever amount you choose to convert of your 250k at your later tax rate. You don't need to pay taxes on all 250k at once. If there is no reason to increase your tax bill today why do so? Rather what benefit is there to converting it to a Roth at this time?

[Stache In Training]

Oh, if you don't do the conversion (to roth) now, I was making the assumption of no conversion ever, as just letting it sit in a traditional and grow is best.

Yes, you don't have to pay the taxes on the 250K all at once, since you're only withdrawing as you need it.  However, you will eventually have to pay taxes on all of it.  That's why when I take a long term approach, I'd rather get it into tax free growth, as opposed to tax-deferred.  The benefit is the same as choosing a roth over a traditional: the taxes will be much less now, when looking at total taxes paid... this is really only because it's such a small amount, and how much time it has to grow.  If it was much more (or if he was closer to retirement age), than yes I'd wholeheartedly agree that just converting into a traditional is best. 

I look at it as this; when I'm 60, would I rather have paid a little bit of taxes when I was 20-something, or have all that money be taxed then (at 60+)?  To me, I think my 60-year-old-self will say, "Man, I should have just paid the taxes on 2,500."

[Iron Mike Sharpe]

Why would taxes be much lower now?  The money I'm putting into my 401K right now, I would be paying the 25% bracket on.  But, when I retire, I would be at the 15% bracket (if that % does not go up) on withdrawals from the 401K.

[matchewed]

Oh, if you don't do the conversion (to roth) now, I was making the assumption of no conversion ever, as just letting it sit in a traditional and grow is best.

Yes, you don't have to pay the taxes on the 250K all at once, since you're only withdrawing as you need it.  However, you will eventually have to pay taxes on all of it.  That's why when I take a long term approach, I'd rather get it into tax free growth, as opposed to tax-deferred.  The benefit is the same as choosing a roth over a traditional: the taxes will be much less now, when looking at total taxes paid... this is really only because it's such a small amount, and how much time it has to grow.  If it was much more (or if he was closer to retirement age), than yes I'd wholeheartedly agree that just converting into a traditional is best. 

I look at it as this; when I'm 60, would I rather have paid a little bit of taxes when I was 20-something, or have all that money be taxed then (at 60+)?  To me, I think my 60-year-old-self will say, "Man, I should have just paid the taxes on 2,500."

But you're not taking into consideration tax brackets. In your earning years you are more likely in a higher tax bracket. This is all based on the assumption (and it's a good one or you wouldn't be able to save) that you need less to live on than you earn. So defer your taxes on your savings as you are in a higher income during your accumulation phase of FIRE. Once you FIRE you'll be pulling in less income than when you work so you pay less in taxes.

Again rather than just say "I think I may want to have paid those taxes in the past when I'm old." we can use math to tell us if it's a good decision or not.

Without details we're both just throwing darts in the dark, but generally as you earn money from a job you're in a higher income than when you FIRE.

[Stache In Training]

Why would taxes be much lower now?  The money I'm putting into my 401K right now, I would be paying the 25% bracket on.  But, when I retire, I would be at the 15% bracket (if that % does not go up) on withdrawals from the 401K.

It's only lower when looked at total amount paid.  25% of 2,500 is less than 15% of 250,000.  625 vs 37,500, respectively.   (The 250,000 number is based on the 2,500 growing at 10% return, and has been used in this example as an easy number to use.  We don't know what it would technically be, but probably around that.)

That 37,500 is an entire year's (or two) "salary" in FIRE.  So you just bought yourself 2 extra years of salary in retirement, for $625.  Of course then you could argue, 'but you're missing out on the growth of 625.'  And so that's just the personal question you have to answer.  Would you rather pay 625 now, to not have to pay 37,500 over time in retirement, or want it all to grow and pay 37,500 in taxes during retirement?

As I said, since it's such a small amount of money, is why this is even debatable.  If it's much more, then no, it wouldn't be worth it to pay the taxes at the higher rate now.  But since the taxes are small enough, I feel that it's best to put it in tax free growth, instead of tax deferred, especially at the OP's young age.

[beltim]

Why would taxes be much lower now?  The money I'm putting into my 401K right now, I would be paying the 25% bracket on.  But, when I retire, I would be at the 15% bracket (if that % does not go up) on withdrawals from the 401K.

It's only lower when looked at total amount paid.  25% of 2,500 is less than 15% of 250,000.  625 vs 37,500, respectively.   (The 250,000 number is based on the 2,500 growing at 10% return, and has been used in this example as an easy number to use.  We don't know what it would technically be, but probably around that.)

That 37,500 is an entire year's (or two) "salary" in FIRE.  So you just bought yourself 2 extra years of salary in retirement, for $625.  Of course then you could argue, 'but you're missing out on the growth of 625.'  And so that's just the personal question you have to answer.  Would you rather pay 625 now, to not have to pay 37,500 over time in retirement, or want it all to grow and pay 37,500 in taxes during retirement?

As I said, since it's such a small amount of money, is why this is even debatable.  If it's much more, then no, it wouldn't be worth it to pay the taxes at the higher rate now.  But since the taxes are small enough, I feel that it's best to put it in tax free growth, instead of tax deferred, especially at the OP's young age.

No no no no no.  You're forgetting about what the $625 would turn into.  Here are the options:

1: $2,500 invested in a traditional IRA turns into $250,000 (incidentally, at the mentioned 10% rate, that would take 48.3 years..how was that chosen?).  At retirement, that's worth $212,500 at the 15% tax rate.

2. $2,500 reduced by 25% gives $1,875, which compounded for 48.3 years at 10% $187,500.  This can be withdrawn tax-free.

Obviously situation 1 is better in this case.  It assumes the information given earlier was accurate, but it's really important to take compounding into account. 

[Stache In Training]

Here, to end it all, I've put these stats into a traditional vs roth calculator. It takes into account the money withdrawn now, and the different tax brackets you're in now and will be at retirement, etc.  Here's the link so you can do it yourself. (http://tcalc.timevalue.com/all-financial-calculators/retirement-calculators/ira-vs-roth-calculator.aspx?IRAAMOUNT=%242%2C500.00&TAXBRACKETNOW=25.000+%25&TAXBRACKETRETIRE=15.000+%25&ROI=10.000+%25&CONTRIBUTION=%240.00&BEFOREAFTER=After+Tax&MAXSHELTERED=%240.00&YEARSTILLRETIREMENT=35&COMPUTE=COMPUTE&CALCULATORID=RC01&HIDEFORMTAG=TRUE&TEMPLATE_ID=www.timevaluecalculators.com_1&PostBack=true#results)

I used 35 years (Since that will put the OP at age 60.), with no further contributions. So attached is the screenshot showing 5,000 extra dollars after taxes, if converting this to the roth now.

[beltim]

That calculator adds additional money to pay for the taxes on the Roth conversion, which was never mentioned here.  And then "to make it fair" it adds that money to the traditional IRA side too - but in a taxable account!  That doesn't make any sense at all.

[SoCal Spartan]

Hey everyone,

Thanks for the replies and breakdowns of which option would be better and why.

For what it's worth, I opened a Roth IRA (STAR) with my own funds and will be rolling over the previous 401k into a Traditional IRA. A deciding factor that I didn't mention is in my career field, one doesn't typically end up working at the same company for much more than 5 years or so (if that). My thinking is that having a Traditional IRA to rollover 401k's I accumulate from one company to the next would be the best option to move those pre-tax contributions.

[Trip]

It does make more financial sense to invest in a Traditional IRA/401K instead of a Roth IRA if you believe your tax rate will be lower when you retire

However, there are also people who believe that there is a good chance that taxes at every level will increase over the coming decades.  If you are one of those people, then it may make more sense to choose a Roth IRA today.  Just something to keep in mind