Former WSJ columnist gives advice to iwillteachyoutoberich readers

August 20th, 2008 - 37 Comments

While I was in New York a few weeks ago, I stopped by to meet Jonathan Clements, the former columnist for the Wall Street Journal — which I thought was the best personal-finance column in the country. (Here’s one of his columns: Twenty Tips for No-nonsense Investing.)

Jonathan Clements

Jonathan is now the director of financial guidance at MyFi. While I was there, we chatted for almost two hours (he’s hilarious) and I asked if he’d be willing to write up his thoughts on the most important step for iwillteachyoutoberich readers. Here’s what he had to say.

There’s no debate over the top priority. If you’re new to the work force, you ought to be funding your employer’s 401(k) plan, because it will give you a trio of benefits: an upfront tax deduction, tax-deferred growth and maybe a matching employer contribution.

But that brings us to the more interesting question. What should your no. 2 priority be? Forget building the six-month emergency reserve or saving for a house down payment. Instead, I would vote for funding a Roth IRA.

With a Roth, all your withdrawals once retired should be tax-free. True, unlike a regular IRA, a Roth won’t give you an initial tax deduction. But if you’ve just entered the work force and you are on a relatively low salary, that tax deduction probably isn’t worth all that much.

Meanwhile, here’s the sweetener: At any time, you can withdraw your original Roth contributions without triggering taxes and penalties. Let’s say you stash $5,000 in a Roth every year for four years. You could pull out your $20,000 in contributions and, provided you didn’t touch the account’s investment earnings, there shouldn’t be any taxes owed.

That means your Roth could double as your emergency reserve, your house down payment money, your car purchase fund or be used for any other purpose. (There is another provision that allows first-time homebuyers to make tax-free Roth withdrawals. To take advantage of this, the Roth has to be open five years and the amount is limited to $10,000.)

Ideally, you would leave your Roth to grow untouched until retirement. That way, you’ll get the most out of the tax-free growth. But if you
need it, the Roth offers wonderful financial flexibility. To learn more, head to www.fairmark.com.

I’ve written about Roth IRAs and 401(k)s in The World’s Easiest Guide to Retirement Accounts.

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37 Comments

 

Comments

  1. What’s step #3? Have the emergency reserve?

    I know exactly what I spend (track it monthly), spend less than I make, , have no debt, save ~40-50% of my paycheck, max out my Roth and 401k, have 2 years of Emergency cash assuming my spending is the same, etc.

    I guess I should start optimizing my ROI? That’s where I’m stuck. What next? I feel like I’m in a financial standstill. I’m doing the right things, it seems, but how can I do more?

  2. I am kind of surprised that he didn’t suggest creating an emergency fund as your second option. With a Roth IRA you can’t take the money out without big deductions until you reach retirement. A lot of younger people with new jobs usually have big expenses to start (i.e. ring, house or rent payments, car payments, etc.). It’s kind of hard to argue, especially with his background.

  3. Tom, you can actually withdraw the principal (the amount you contributed) at any time — even before retirement — tax-free and penalty-free.

  4. If you withdraw money from your Roth IRA as an emergency fund can you put the same amount back in at a later time? My understanding is that you can only put in 5k per any year. Say you withdraw 15k for an emergency but can only put back in 5k a year, aren’t you effectively sabotaging this retirement fund?

  5. I miss Johnathan Clements

  6. Really. I have had a Roth since I was 16 (now 26). My wife and I are facing some big expenses (like Tom said, rings, wedding, and down payment). Ramit, you might have to say it again. You withdraw the principal at anytime — tax-free and penalty-free?

    I heard of $10,000 for a home but, never heard of anything else.

  7. Hey Daniel, have you searched online for something like “Roth IRA withdrawal”? I say this because everyone should be getting multiple sources of information (not just iwillteachyoutoberich), and not knowing isn’t a good enough reason to not do something with your money — it’s just one search away!

  8. Any thoughts on the new MyFi program? I’m skeptical, but with Clements there, I’d be willing to give it a look.

  9. Using a Roth as a replacement seems for an emergency fund seems like a great long-term idea, but I’m not so sure if it would work as well in a short-term window. For example, my investment of $20K over 4 years may be significantly lower if the market happens to suffer during that time period. Of course, having a longer period of time to ride out the ups and downs would be best, but it’d be a tough pill to swallow if my house deposit savings were less than what I initially put in the Roth. Just my two cents though.

  10. Honestly….i dont know if im messing up my future…but i say screw 401K. im doing it the traditional way of saving after tax money. im 32 and so far my net worth is a little more than $500K. 2 cars both paid off. house paid off.

    401K : zero

  11. What about non US citizens? 401s and Roths are not for us.

  12. I’m surprised to see Clements associated with MyFi, a division of Citi Smith Barney.

    I’ve always enjoyed his WSJ columns and remember him consistently encouraging readers to seek the help of fee-only, fiduciary advisors. Due to the regulatory environment, there is no way anyone associated with Citi Smith Barney can operate as fee-only or as a fiduciary. This seems counter to his past advice and writing.

    Interesting . . .

  13. This sounds good but what if your stocks are not doing so hot? For example, if you invest $5,000 in a bad year and your balance goes down to $4,500. If you decide to withdraw that $4,500, then your balance is effectively $0, no? I’d rather leave my IRA alone and just pile up some savings in a money market.

  14. Jonathan: Curious, why would you withdraw money from your IRA just because it went down? That speaks more to rebalancing your portfolio to be conservative, not rashly withdrawing your money. It sounds like you probably have a lower risk tolerance, so I’d build a portfolio accordingly. But taking all your money out of your IRA is probably the worst thing you could do.

  15. Hi Ramit,
    I’m 24, have been working for a year at my first salary job, and my employer offers a Roth 401(k). I recently stopped contributing to the regular 401(k) and now put 6% into my Roth 401(k) (They match 50% up to 6%). Since Roth 401s relatively new I haven’t seen or heard much about them, but I have to assume you’re getting the benefits of a Roth IRA with the match of a 401. Their match goes to the traditional 401 for tax reasons but my retirement withdrawls will be tax free when I’m in a higher tax bracket later in life. Do you think this is a good idea or should I be splitting my contributions 50/50 between the two? Great blog, thanks.

  16. Wow! To think that I hadn’t heard of this tax-free withdrawal of Roth IRA contributions. I read an entire pamplet a few years ago regarding the Roth IRA and somehow through all the convoluted language (or simply my own inability to read and comprehend) I missed this. How wonderful! I just rearranged my budget and now it looks like it will be possible for me to fund almost my entire 401(k) – no company matching unfortunately – as well as fully fund my Roth. Thanks so much! If a number of readers on your blog didn’t know this, I’m afraid to think of how many other people out there aren’t taking advantage of this this.

  17. His advice is what I typically recommend as well. However, the devil is in the details, and to get the most out of you buckets, you’ll want to look at everything closely.

    For example, some 401k offer no matching and the few funds frankly stink. In cases like that, it may actually be worth funding your own IRA instead. Roth IRA is excellent, but it works best if you can get yourself in the 15% income bracket. Anything higher, and you may want to consider a traditional instead, or end up paying more taxes than you have to. Also, you may actually want to use a taxable account instead of a Roth if you know you’re going to be pulling money out very soon or frequently. Once you contribute to a Roth, that money can’t be put back.

    I’m sure he alreayd knows all knows all this as well, and is merely dispensing a simplified explanation for the sake of space and simplicity. His recommendation is similar to my setup. Use the 401k to get myself into the 15% bracket. Contribute the Roth that doubles as a secondary emergency fund, but also have a cash savings account that works as my primary emergency fund.

    In any case, very cool that you got to talk to Jonathan Clements!

  18. Derek, I’m not ramit, but if you don’t mind me taking a stab at it, it really depends on what income tax bracket you think you will end up in later in your life as opposed to what bracket you are not. If you are in the 25%, it can go either way, but if you are in 28%, I’d definitely focus on the regular 401k instead.

    While we may not know what bracket we may be in later in life, I think most of us can figure out a way to get ourselves into lower tax brackets, wouldn’t you say? :-D That and some worry about the rules on the Roth being changed, which I don’t necessarily agree… but it’s possible.

    What we do know and can work with is what tax bracket we are in, here and now, and that’s what I’d focus on.

  19. A quick clarification about the Roth if I may. The Roth is not actually tax-free in the sense that you will never pay taxes on it. It’s tax-free in the sense that you don’t have to pay taxes on it LATER because you’ve ALREADY paid the taxes for it.

    But because it’s already taxed, that’s why it offers so much flexibility, because that money is basically yours to do as you please. Uncle Sam has already taken his cut.

    Still, if you’re in a high income bracket, the Roth could actually be worse off than a traditional. For example, it’s possible for someone to end up paying 25% or more using the Roth, whereas later on, they can scale down to a part-time job or non-profit gig that they love and end up paying only 10% or 15% tax on that same amount of money with a traditional IRA or 401k. Again, it just depends.

  20. I don’t agree with using your Roth as your emergency fund. Maybe some people are disciplined but many people once they pull their funds from the Roth will have a hard time putting them back.

    You need a separate emergency fund.

  21. This is exactly what I needed, I’m getting ready to roll over my 401K from my former employer into a Roth IRA. Is this a good move? Any advice? I totally forgot that you can withdraw your principal amount from your Roth IRA. Thanks for the post!

  22. The Roth IRA is definitely one of the best ways to save money but I think people will miss the point of a Roth if we say one of the major strengths is that you can withdraw your principal at any time without being penalized.

    Granted, it’s a benefit but don’t Americans already have way too much trouble with the discipline of saving in general? I think we should be pushing the fact that you won’t be taxed at retirement instead but I guess whatever gets people to invest in save is winner… even if you have to tell them they can spend that money whenever they want. lol

    Great post by the way, even if I didn’t really agree with the article’s slant.

  23. ekrabs, Derek, Ramit,

    One thing that seems to be glossed over is that when you contribute to a Roth IRA or Roth 401k, you are taxed at your highest marginal tax rate. If you contribute to a traditional 401k, when you withdraw the money in retirement, it will be taxed progressively. For instance, if your income was 40,000 you would be taxed at 25% for the roth and for traditioanl, if you withdrew that amount as your only income you would be in the 25% tax bracket but only pay 14% of that sum as tax.

  24. Thanks for point that out Joe. Didn’t mean to gloss it, but that’s why I use my 401k to not only get my match, but to also get myself into the 15% bracket. After that, it’s pretty much a non-issue. That’s also why people need to be aware of which bracket they’re in when considering which retirement accounts are the best for them to use.

    But just so it’s clear, the Roth isn’t always taxed at its highest marginal rate. However, it may seem like it if you’re making $40k, because your entire $5k contribution would seem like it lands on the 25% mark. Again, the money you put in the Roth is already taxed accordingly before you even contribute, so in reality, there’s really no special tax issues when it comes to the Roth.

    topseekrit, conversion is ideal if and when you can keep your taxed income in the 15% bracket AND if you have available cash to pay the taxes for the conversion. It’s better to use spare cash rather than dipping into your own fund to pay for the the conversion. If that’s not possible, I’d break the conversion down to smaller, more manageable chunks and spread it out over the course of several years until you get it all in there.

  25. You bring up a good point. Why fund an emergency fund that may only net 4% in a great online account, when it could be earning 8-10% in a ROTH.

    Besides, interest on the online bank account will be taxed. Nice call, didn’t think like that before. Thanks.

  26. @Ekrabs I believe the longer you hold a a fund, you should lean more towards ROTH? If you invest for 25 years, that means 25 years worth of profits that will be taxed. If it was ROTH, only original contributions will be taxed.

    If you invested $500/month for 25 years, that would be 150k invested. Interest at 8% would be almost 330k on top of that 150k. With a regular IRA, you would have to pay taxes on the entire 480k. Let’s say you do have a lower paying job, and are only taxed 15%. That’s still 72k in taxes. If you would have already paid with taxed dollars into a ROTH, you would only pay taxes on the original 150K, say at 28%, that’s only 42k in taxes. You are right, it depends. I would say they longer you plan to hold the investments, the more you should invest in a ROTH.

    Please correct me if I am wrong. Thanks.

  27. Tage, I understand your premise, but because you’ve already lost money (opportunity cost) on the taxes that is already paid on the Roth, that’s money you won’t be able to use or grow. The only difference is that you don’t see the tax penalty as clearly with the Roth as you would with the traditional.

    Does that make sense? A more artificial but clearer way of looking at it is to pretend that you’re young and you make only 1k. Out of that 1k you made, you got taxed 10%, so you’re left with $900. So, in reality, that’s only $900 total you can put into a Roth due to taxes. Contrast with, say, putting it into a 401k example, where you can put the the entire 1k and let it grow until later.

    So, in terms of strictly just taxes, it actually works out about the same, whether you decide to use the Roth and Traditional. That’s why it’s so important to look at tax brackets. After all, between 15% and 25%, we’re looking at a potential savings up 10% into our pockets, easy! Now expand that concept to a span of 30 years and… the end result can be mind-boggling.

    That said, I typically lean towards the Roth too, but again, the devil is in the details.

  28. Ah, yes that makes sense as well. Luckily, it shouldn’t be that hard to max your Roth, and max out your 401k up to the point where you get your employer match. But it does seem a lot more complicated than just a surface look. Thanks!

  29. Great point on the Emergency fund. I contribute to my Roth IRA regularly instead of saving for a house. My money grows a lot faster in that account compared to a savings or CD, even in this turbulent economy It’s done alright.

  30. If you view your retirement fund as a way out in an emergency, it blurs the line.
    My wife and I are just starting our path to financial freedom – 15,000K in debt, two cars, and a mortgage. And if I were to allow ourselves to blur the line there, than whose to say the blurred line can’t extend to using credit cards when they’re paid off.

    Here is why this doesn’t work (respectivley of course):
    1. No matter how you look at it you are extending your debt. You are in debt to yourself – but you’re still in debt.
    2. Borrowing from yourself perpetuates the borrowing mentality.
    3. Whatever money you pull out is no longer earning interest (more money, more compounding), so you are in a sense sabotaging your future.

    It’s an interesting discussion however, and if I didn’t have an emergency fund large enough to cover something and my Roth was big enough – I would definitely use that before going outside.
    But my path is to build that small emergency fund ASAP and contribute to it afterward 10% in addition to building my ROTH

  31. Off topic but…
    As far as the ROTH vs Trad IRAs here are some numbers:

    Say you invest $2,000 each year into each ROTH and Trad:
    You invest to 30 years and you are able to get 12%/yr compounded monthly.

    At the end you would have a lump sum of $660,218.25

    But with the ROTH you would have to earn $3,000 to make the $2,000 contribution (assuming 33% tax bracket). Which means that you have paid $30,000 in taxes spread out over 30 years. Which whittles down your net worth to 630,218.25.

    With the Trad you will end up paying (say 15%) $99,032.74 in taxes all at once. Leaving you with 561,185.51!

    In 30 years your net:
    ROTH TRAD
    630,218.25 561,185.51

    I’d much rather take the $1,000 hit every year and be 90,000 wealthier.

    This of course assumes no employee contribution, in which case I say “don’t pass up the free money, dummy”

  32. @William:

    Your analysis is incorrect because you ignore the Time Value of Money on the taxes for the first 30 years. As you mention, “with the ROTH you would have to earn $3,000 to make the $2,000 contribution (assuming 33% tax bracket)”, but you ignore the potential earnings of that additional money in the traditional IRA. If you compound this amount at the same rate, you’ll see that the two accounts end up being exactly the same.

    Therefore, the only difference in analysis should be the current and expected tax brackets that you will be in.

  33. I think if you use an emergency fund for major emergencies (medical bills, job loss, major repairs, etc) then you shouldn’t really have to make withdrawals that often since these items aren’t likely to happen often, and in this case using the Roth this way is a great idea, plus using it to save for a house is nice too if you’re saving over a longer time period. I think a separate savings account or something that had $2,000 or so in it for the more minor emergencies (miscellaneous car repairs, smaller medical bills, home repairs, unexpected taxes, etc) would be a good thing to have in addition to the Roth emergency fund so you wouldn’t have to sell investments and withdraw money for these more common items that are likely to occur more often. This would help make sure that the Roth withdrawals are only for major emergencies and you’re not likely to sabotage yourself by making a bunch of withdrawals each year.

  34. Jeremy,
    At the risk of hijacking the post, I’ll try to keep this short.
    I see your point, and you would make a considerable amount more not equal amounts. Like 200,000 more.
    But I’m talking about equal amounts invested.
    Say you invest the maximum amount of $5,000…

    ROTH you must invest $6,650 for a total of $5,000 ($1,650 in tax every year at a total of $49,500).
    TRAD $5,000 for $5,000 (no tax – and you can spend the extra money on bubble gum – something as useful as the IRS)

    At the end of 30 years at 12% you would have over 1.65 million in each account (I can only dream….)

    BUT… with the Traditonal IRA you would owe $247,500 assuming 15% at retirement.

    It all comes down to the fact that the money you put in is ALL YOURS!!! And you can obviously see that you end up with more.

    Feel free to email me directly if you feel like discussing this further. And anyone should feel free to correct my math.
    Remember I’m comparing equal invested amounts… The ROTH is taxed up front and the traditional is taxed later.

  35. William, all else being equal, the amount you’ll end up with is the same regardless of which vehicle you choose. But the key here is “all else being equal”, which I realize is arbitrary, but it’s the only way to realize that both vehicles use the same income tax brackets.

    The first example you have provided is slightly confusing in that you have chosen the Roth to be in the 33% bracket whereas you have chosen the Traditional to be in the 15%. While something like that (not 33% but maybe 28%) can Very Much happen in real life– and exactly illustrates why considering tax brackets are so important– this is not a fair way to conclude that one retirement account type is better than the other….

    In your second example, you did not factor in the opportunity cost lost in the Roth’s tax money being allowed to grow because it’s already been paid as tax. If you factor that in and compound it accordingly, I think you’ll see that it once again ends up being the same.

    I hope that I am not giving you or anyone a hard time about this. I’m glad to see so many people being interested in this subject matter, as you’re all going to be far richer than I am. :-)

    I don’t know if I’m at liberty to say this, but Ramit has a forum where we can take this discussion and many more into further detail. Of course, this is Ramit’s house, so please ask him for permission if you are interested.

  36. I remember reading him back in the day. Plus a story he wrote about 401(k)s somehow got linked to a post of mine and gave me my very first spike in traffic last year.

    I agree that the Roth and the Em fund should be separated if at all possible. Otherwise you don’t really have an emergency fund, you have an “I’m risking my future retirement well being” fund.

  37. I find this interesting because I recently took a distribution on my Roth contributions. So, I’m glad I knew of this option but I was confused with some questions asked by the company (a major one) who services my account.

    When finishing the transaction over the phone, they asked me if I wanted to tax the amount now or handle it at tax time. What? I said no, send me the full amount requested.

    I called back a few days later to gain some clarity. The rep said they are required to ask the question about taxes. Okay, fine I said, I just want to make sure I don’t receive a 1099. She replied they are required to generate a 1099 for all distributions regardless. Does this sound right? Will the 1099 show $0 for the taxable amount?