The most popular investing question people ask me is how much they should invest. Assuming it makes sense for their financial situation, I usually encourage them to invest as much as they can.
A common follow-up question they ask is what type of account they should open. This question is a bit trickier to answer depending on their financial situation. When deciding on which account to open, it is important to consider many factors including tax diversification. In a previous article, I discussed this in depth.
Both of these are great questions. However, in my opinion, many people do not put much thought into how often they should make contributions. Depending on your goals and risk tolerance, some strategies are better than others.
In this article, I will go over these strategies in the context of Roth IRA contributions.
What is a Roth IRA?
A Roth IRA is a retirement savings account that allows your money to grow tax-free. You fund a Roth IRA with after-tax dollars. This means you have already paid taxes on the money you put into it. In return for the lack of up-front tax break, your money grows tax free. When you withdraw at retirement, you pay no taxes.
The main difference between a Traditional IRA and a Roth IRA is when you pay taxes on your investments. Traditional IRAs can delay the taxes until retirement. When you contribute to a Roth IRA, you pay tax now rather than later.
Roth IRAs offer a bit more flexibility than Traditional IRAs. You may withdraw your contributions to a Roth IRA penalty-free at any time for any reason. Note, you will be penalized for withdrawing any earnings before age 59 ½ unless it is for a qualifying reason.
Like Traditional IRAs, Roth IRAs have maximum contribution limits and income eligibility requirements.
Note, you may make a contribution anytime from January 1st to the tax filing deadline. For example, you can make a 2019 contribution from 1/1/19 to 4/15/20. In the following year, you can make a 2020 contribution from 1/1/20 to 4/15/21.
To learn more about Roth IRAs, visit the IRS website.
How Often Should I Contribute?
Once you open your Roth IRA, it is time to fund it. You can do this in several ways. One option is to contribute a lump sum for the entire year. Another option is to set up monthly contributions. Alternatively, you can do a combination of both.
Lump Sum Contributions
As of 2020, the total amount you can contribute to either a Roth IRA or a Traditional IRA is $6,000. People 50 and over can contribute an additional $1,000 for a total of $7,000.
Markets tend to go up over the long-run. The longer you have your money in the market, the longer is has to grow in value. Therefore, contributing a lump sum at the beginning of the year has a higher chance of outperforming monthly contributions.
If you invest everything right before a market correction, you will experience a bigger short-term loss than if you spread out your contributions on a monthly basis. Lump sum investing will not make sense for people who cannot tolerate this. Also, lump sum investing is not an option for those who do not have the funds to make a contribution right away.
On a monthly basis, the total amount you can contribute to either a Roth IRA or a Traditional IRA is $500 per month. People 50 and over can contribute $583.33 per month.
It is easier for most people to contribute a few hundred dollars each month versus making an annual lump sum contribution of several thousand dollars.
Also, making monthly contributions takes market timing out of the equation. If there is a market correction, you will end up buying more shares at a lower cost.
Since markets tend to go up over the long-run, you will most likely buy shares at a higher price over time. Therefore, contributing on a monthly basis has a higher chance of underperforming lump sum contributions.
Regardless of which method you choose to fund your Roth IRA, it does not pay to wait to invest.
If you have a higher risk tolerance and the ability to make a lump sum contribution, you may want to make one at the beginning of the year.
If you do not have the funds to make a lump sum contribution, monthly contributions lessen short-term market risks. Also, it helps automate the investment process.