With all the bad tax news about the fiscal cliff dominating the financial headlines in the United States, I thought it might be worth adding some good news to the conversation about upcoming changes to Roth IRAs for long-term investors. According to the IRS, eligible Roth IRA investors will be allowed to increase their annual contributions from the $5,000 mark in 2012 to $5,500 in 2013 (and if you're over 50, you are allowed to increase your contribution from $6,000 to $6,500). A press release from the IRS noted the following changes:
· The limit on annual contributions to an Individual Retirement Arrangement (IRA) rises to $5,500, up from $5,000 in prior years.
· The deduction for taxpayers making contributions to a traditional IRA is phased out for singles and heads of household who are covered by a workplace retirement plan and have modified adjusted gross incomes (NYSE:AGI) between $59,000 and $69,000, up from $58,000 and $68,000 in 2012. For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $95,000 to $115,000, up from $92,000 to $112,000. For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple's income is between $178,000 and $188,000, up from $173,000 and $183,000.
· The AGI phase-out range for taxpayers making contributions to a Roth IRA is $178,000 to $188,000 for married couples filing jointly, up from $173,000 to $183,000 in 2012. For singles and heads of household, the income phase-out range is $112,000 to $127,000, up from $110,000 to $125,000. For a married individual filing a separate return who is covered by a retirement plan at work, the phase-out range remains $0 to $10,000.
That extra $500 that you can put away per year is nothing to scoff at. To get a glimpse of what a mere $500 investment can do over long periods of time, let's take a quick look at the performance of a $500 investment in some high-quality blue chips over the past 20 years. Since 1992, a $500 investment in Procter & Gamble (NYSE:PG) would be worth $4,200. A $500 investment in Johnson & Johnson (NYSE:JNJ) would be worth $4,900. For Colgate-Palmolive (NYSE:CL), that would be $7,300. And the best thing is, all of these returns will be tax-free, created by a single $500 investment. For me, that's like putting aside an extra month's worth of rent so that I can get an extra $170 or so in annual income from Colgate-Palmolive 20 years from now. No, there is no guarantee that the companies will have similar performances over the next 20 years, but it's nevertheless possible that these small amounts can create meaningful wealth when allowed to compound in tax-free accounts.
The Roth IRA is one of, if not the, best tax break for middle-class households in the developed world. The tax-free wealth that can be created by a Roth IRA is nothing short of staggering (remember, the examples above just listed the effects of a $500 investment. That's nothing compared to the results of contributing $5,500 annually for 40 years). We're fortunate that the Taxpayer Relief Act of 1997 incorporated a cost-of-living adjustment that has enabled the maximum Roth IRA contribution level to rise from $2,000 in 1998 to $5,500 in 2013.
And here's the fun part: all it takes is one lights-out investment to make the Roth IRA the greatest accounting structure that's ever happened to you financially. Take a stock like Altria (NYSE:MO). Pretend that Roth IRAs existed in 1972, and you were allowed to contribute $5,500. A $5,500 investment would now be worth $3.41 million. And that would have just been a single year's contribution in a tobacco manufacturer that everyone in the country was familiar with at the time. That would give you just shy of $200,000 in annual dividends coming in tax-free every year. That single decision in 1972 would have been life-changing.
I'm not promising anyone those kinds of returns over the next 40 years, but it can be quite amazing to see what happens if a McDonald's (NYSE:MCD) or a Wal-Mart (NYSE:WMT) constitutes one of your long-term investments in a Roth IRA. The tax-free returns can be quite lucrative. If you're in a position to contribute the $5,500 with the coming raise to the Roth IRA, be sure to take advantage of it. If you pick an intelligent investment, there is no other holding structure in the country that will allow you to reap the rewards of your investment quite like a Roth IRA.
Disclosure: I am long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.