Blog Money Whore

Let’s say you just graduated from college and got a decent job. You have a little extra cash on hand after taxes and are wondering if you should buy a big screen TV or save for retirement. You’re probably going to buy the big screen because that’ll allow you to have an incredible Super Bowl Sunday, but due to your nagging parents, you realize that having some savings is pretty important. What should you do?

Well, ask yourself this question: would you rather have $4000 now or $1.6 million in 38 years?

Seriously, $1.6 million.

Let’s make some assumptions:

1. You just graduated from college and are 22 years old.
2. You will start withdrawing money from your Roth IRA at 60 years old (the earliest without penalty is 59 1/2).
3. Your money grows at 10% per year, which is not at all impossible given 38 years of semi-risky growth.
4. You contribute $4000 per year to your Roth (the maximum allowed amount is going up in the future!).

Well, if you do all those things, then you will have $1.6 million in tax-free money at the age of 60. That’s pretty freaking awesome! For $1.6 million, you can easily forget that you’re old—just buy a new hip and splurge a little on that cute 22-year-old tart who doesn’t know enough to save money but who looks incredible to your sexagenarian eyes. If you can hold out until the age of 65, then you’ll have $2.6 million in tax-free money. That’s freaking incredible! Thanks to compounding interest and good saving, you’ve become a millionaire while working a crappy 9-5 job and you probably won’t have to work another day of your miserable life.

Don’t believe me? Download this Excel spreadsheet and put the numbers in yourself. You can easily adjust your annual contribution and growth rate. You can even make the model more complicated if you want. See what happens if you only contribute $2000 a year (you still become a millionaire) or your money only grows at 7% per year (you still become a millionaire).

What are you waiting for? You still have until Tax Day to make your contribution for the previous year, and the earlier you do it, the longer your money can grow! Yeah, saving isn’t exactly on most people’s minds at the age of 22 (trust me, I know as a 25-year-old who looks like a teenager), but it really pays off!

In 2007, I contributed too much to my Roth IRA. The max per year is $4000, and I thought I could contribute the max but the year didn’t work out that way. Uh oh, what to do? Well, the IRS can at times be understanding, so there’s a procedure in place, which is outlined in Publication 590:

A 6% excise tax applies to any excess contribution to a Roth IRA.

Excess contributions. These are the contributions to your Roth IRAs for a year that equal the total of:

 

1. Amounts contributed for the tax year to your Roth IRAs (other than amounts properly and timely rolled over from a Roth IRA or properly converted from a traditional IRA, as described later) that are more than your contribution limit for the year (explained earlier under How Much Can be Contributed?), plus
2. Any excess contributions for the preceding year, reduced by the total of:

    

   1. Any distributions out of your Roth IRAs for the year, plus
   2. Your contribution limit for the year minus your contributions to all your IRAs for the year.

Withdrawal of excess contributions. For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made.

Applying excess contributions. If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year.

All I see is “blah blah blah”, but at least I know I’m not in some sort of big trouble!

However, all this makes for an interesting point: if you had a good year, then you might as well pay the 6% excise tax. Why? Well, if you withdraw the money, then you’ll have to pay taxes on those earnings, which may be much more than 6%! As long as you expect to be able to apply those excess contributions in the future, then you will likely save/make more money by contributing the max as early as possible to your Roth IRA to give your money as much time as possible to grow tax-free (aside from that possible 6% excise tax).

Am I missing something here???

Also, in case you’re wondering how to calculate the amount to withdraw, then check out this Investopedia article. It explains that it’s simply done on a pro rata basis on the total fair market value of your Roth IRA. Although this may be a pain to calculate by looking at old account statements, I think most brokers have procedures in place to automatically withdraw excess contributions. Mine does. All I have to do is tell them how much the excess contribution is, and they calculate for me what the earnings are on that amount.