Jane Young, CFP, EA
You may be hesitant to invest in the stock market because it feels too risky. However, consider the risk you are taking with your financial future by avoiding the stock market. The primary reason to invest in the stock market is the potential for a much higher return, especially in low interest rate environments. Most of us need the potential for long term growth provided by the stock market to meet our retirement needs. If you invest all of your money in fixed income you may struggle just to keep up with inflation and you run the risk of outliving your money.
Historically, stock market returns have been almost double those earned by bonds. According to the Ibbotson SBBI (stock, bonds, bills and inflation) report, between 1926 and 2014 the average annual return on Small Stock was 12.3%, Large Stock was 10.1%, Government Bonds was 5.5%, Treasury Bills was 3.5% and Inflation was 3%. This illustrates that investing at least some of your portfolio in stock can provide a much greater opportunity than fixed income to meet your financial goals.
Investing in the stock market is not without risk. As with all investments, we must take on greater risk to earn a greater return. However, there are many ways to help manage the volatility of the stock market. Before investing in stocks make sure your financial affairs are in order. Pay off your credit cards, establish an emergency fund and put money that will be needed over the next five years into less volatile fixed income investments. The stock market is for long term investing. It can provide the opportunity to earn higher long term returns but you can count on some volatility along the way. By creating a buffer to cover short term needs you will be less likely overreact to fluctuations in the market and sell when the market is down.
You can also buffer stock market risk by creating a well-diversified portfolio comprised of mutual funds invested in stocks or bonds from a variety of different size companies, different industries and a variety of different geographies. Investing in a single company can be very risky but investment in mutual funds can reduce this risk. When investing in mutual funds your money is combined with that of other investors and invested, by a professional manager, into a large number of stocks or bonds. Investing in a large number of companies enables you to spread out your risk.
Dollar cost averaging, where you automatically invest a set amount on a regular basis – usually monthly or quarterly, can also reduce risk. Rather than investing a large amount all at once, when the market may be high, you gradually invest over time. With dollar cost averaging you buy more shares when the market is low and fewer shares when the market is high.
Jane Young, CFP, EA
A Roth IRA can be an excellent vehicle to save for retirement but it’s not without limitations. With a Roth IRA you invest after-tax dollars that grow tax free and can be withdrawn tax free in retirement. This can be beneficial unless you are currently in a high tax bracket and anticipate being in a lower tax bracket in retirement.
Income limitations can be a significant downfall with Roth IRAs. During your highest income years you may be ineligible to invest in a Roth IRA and there can be substantial penalties for making ineligible contributions. In 2015 the income limit for someone filing single begins at $116,000 and the income limit for someone filing married filing jointly begins at $183,000. If you make a contribution and your income exceeds the limitations, you have until your tax deadline, including extensions to withdraw your contribution. It’s easy to inadvertently make ineligible contributions and there aren’t many red flags to alert you to the problem. If you don’t withdraw excess contributions within the deadline you will incur a 6% penalty for every year the money remains in your Roth IRA.
Also be careful not to exceed the annual Roth IRA contribution limits. In 2015 the contribution limit for investors under 50 is $5,500, if you are over 50 you can make an additional catch-up contribution of $1,000. Also keep in mind that Roth IRA contributions can only be made with earned income.
If your earnings exceed the income limitations and you still want to participate in a Roth IRA, you may have several options. Your employer may offer a Roth 401k in addition to a traditional 401k. With a Roth 401k, your employee contributions can go into the Roth option but the employer match must go into a traditional 401k. A second option is to convert a traditional IRA to a Roth IRA but the amount converted is taxed as regular income in the year of conversion. As a refresher, with a traditional IRA and 401k you invest with before tax dollars and you pay regular income tax on the full amount when you withdraw the money. Finally, you can consider investing in a non-deductible IRA and immediately convert it to a Roth IRA, also known as a backdoor Roth IRA.
Initially, the backdoor Roth sounds like the perfect solution because there is no income limitation on a non-deductible IRA and it’s funded with after tax dollars. Theoretically, immediate conversion to a Roth IRA should be tax free. The hitch comes from the IRS rule requiring you to aggregate all of your IRAs and proportionately include money from all IRAs in your Roth conversion. Traditional and rollover IRAs are comprised of pre-tax dollars so the proportion of the conversion coming from these IRAs will be taxed as regular income. Although backdoor Roth IRAs can be complex but they can be a good option if you don’t own other IRAs.