As the advisor of Motley Fool Income Investor, I've said many times that the Roth IRA is an ideal vehicle for dividend lovers. This is particularly true for those who intend to invest for the long term, where the full benefits of this remarkable account really shine.
Because you don't receive an up-front tax break on your contributions to a Roth IRA, all future growth and income generated by the account will come back to you completely free of tax (as long as you begin withdrawals after age 59 1/2 and the account has been open for at least five years). You're effectively choosing to pay taxes in advance on what you hope will be the lower figure (your contributions) to enjoy what you hope will be the higher figure (the appreciation and income generated by the account) tax-free.
The dividend advantage
But only dividend investors are, arguably, taking full advantage of the power behind these market vehicles. Most folks talk only about the fact that the account's growth will ultimately be tax-free upon withdrawal, but it's just as important to note that the same is true of the income generated by the Roth.
Dividend investors have the opportunity to create a completely tax-free income stream from their Roth IRAs without the need to liquidate any of their holdings. For example, let's assume the Roth existed 25 years ago and you chose to open an account at that time. If you'd made a $1,000 investment in Altria (NYSE:MO) -- formerly Philip Morris -- in 1980, you would have begun with 29 shares of stock. Today, through splits, you'd have nearly 700 shares worth about $50,000. Better still, if you'd let the dividends accumulate as cash in your account, your cash balance would be $18,868. That's a total of nearly $70,000 as a result of your original $1,000 investment.
The power of reinvestment
Those results certainly aren't bad, and I daresay most folks would be quite satisfied with a 70-fold increase in their original investment. But investors who elected to reinvest their dividends over the years did significantly better. With that simple choice, they amassed 2,182 shares worth about $155,000. This sum includes $45,545 in reinvested dividend payments, on which they didn't pay a cent of tax. Note that this is more than double the income received by those who chose not to reinvest.
But here's where it gets truly interesting. Today, your original $1,000 investment would generate an annual dividend income of nearly $7,000. Now, I want you to consider for a moment the magnitude of this marvelous fact. Without having to sell a single share, you'd be positioned to receive $7,000 in annual tax-free dividend income from your original $1,000 Roth investment. And you'd receive this income while, ideally, the underlying value of the account continued to grow. This is a phenomenal benefit that non-dividend investors will never get.
And this is from a single investment! Imagine if you'd invested $1,000 each in 10 companies with similar yields. That, my friends, is retirement flexibility. While the greatest benefits result from investing in companies with above-average yields -- such as Income Investor picks Alliance Capital (NYSE:AC) and AGL Resources (NYSE:ATG) -- even if you'd elected lower-yielding firms and allotted $1,000 each to PepsiCo (NYSE:PEP) and Johnson & Johnson (NYSE:JNJ), you'd have boosted your annual income by an additional $2,500.
Beyond choosing good companies out of the gate, this example best illustrates that the choice to reinvest dividends is the single most important factor in determining your future investment returns.
What the future holds
Besides not offering an up-front tax break, the Roth's main disadvantage is simply that you can't contribute as much money to these accounts as you'd like. After climbing over the past few years, allowed annual contributions for 2005 still stand at just $4,000 -- or $4,500 for those over age 50. While that's an improvement, those contribution levels pale in comparison to those allowed for 401(k) accounts and Simplified Employee Pensions (SEP Plans) -- that is, until now.
In 2006, many investors can opt to contribute to a new Roth 401(k), an account that allows the same contribution amounts as a regular 401(k) (up to $42,000 for 2005). But as the name suggests, the Roth 401(k) will offer the same tax-free growth and income benefit as the Roth IRA.
The account could prove the greatest boon to high salary earners who have seen their ability to contribute to a Roth IRA evaporate as their incomes have grown. (Roth contributions are phased out for joint filers who make more than $150,000 per year.) While I'm not asking you to feel sorry for folks making 150 grand a year, this cutoff is affecting more and more families. Consider the case of a professional couple who each could easily pull down $75,000 annually. Are they too rich to deserve the benefits of a Roth? The answer may be uncertain, but deserving or not, these folks would begin to lose their Roth IRA option. There are no income limitations associated with the Roth 401(k), however, so they can contribute however much money they make. That's going to be awfully good news to this white-collar couple.
The basics
In 2006, you'll be able to contribute $15,000 to a Roth 401(k). (Those over age 50 will be allowed to contribute an extra $5,000 as a "catch-up" contribution for a total of $20,000.) Like the traditional 401(k), however, the best deal may be for the self-employed, who have the same "base" contribution limits but can also contribute 25% of their salaries, up to a total of $42,000. But for all, please remember that the contribution limits remain the same no matter how many accounts you have. So if you maintained your regular 401(k) in addition to opening a new Roth 401(k), you could still only invest up to the limits stipulated above.
Also significant is that the Roth 401(k)'s mandatory distributions mimic those of the regular 401(k), not the Roth IRA. That means you can choose to make withdrawals penalty- and tax-free at age 59 1/2, but you'll be forced to begin taking withdrawals at age 70 1/2 if you haven't done so by then.
The only drawback is that not all employers may offer the Roth 401(k), since it may not be around long if Congress doesn't make permanent the benefits of the Tax Relief Reconciliation Act. In that case, your ability to open a new Roth 401(k) or make contributions to one that you established between 2006 and 2009 would disappear in 2010.
Despite the possible drawbacks, I would push my employer hard to convince them to offer the Roth 401(k), because -- beyond administration -- it makes little difference to them either way but could make a meaningful difference to you. Consider the size of the tax-free income stream that you could amass in retirement with these higher contribution limits. In that case, even if your Social Security benefits do evaporate, you could be in for a golden retirement indeed.
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Mathew Emmert has a Roth IRA, and if he ever retires, he looks forward to a stream of tax-free income. He also owns shares of Altria and PepsiCo. In case you didn't notice, he's the advisor of Motley Fool Income Investor. The Fool isRoth lovers writing for Roth lovers.
