Timing Your Roth IRA Contributions
Jun 30th, 2008 by Carlos
[This post has been included in the Money Hacks Carnival over at Sound Money Matters. Be sure to go over there and check out the other great posts]
Earlier this year I was part of a discussion somewhere online about how and when to contribute to a Roth IRA account. There were two groups of people arguing their own points — since all the investing I do is in my Roth, I was eager to be a part of the discussion. Each side was very vocal about defending their opinion with a host of arguments and points, which was fun. One side felt that it was best to contribute everything you’re allowed to contribute ($5,000) at the start of the year in one lump sum and not worry about it until next year. The other group, meanwhile, argued that you should practice dollar-cost averaging to avoid any huge drops in the market.
Let’s take a look at the two sides, their arguments, and see which one I subscribe to:
One Lump Sum
The argument here is all about convenience and uses some assumptions about the stock market. For one, it’s much easier to do this once a year. As long as you have the money (which is one strike against this theory, since a lot of people don’t have $5,000 laying around), you can just send it to your broker, buy what you want, and be done with it. “Set it and forget it.”
We all know that compound interest is a fantastic thing, and to some that means the sooner you have the money “in play,” the quicker it’ll compound. Which is true, as long as the market goes up in that particular year (which it won’t always). So if the market goes up, you have more money growing. That’s another assumption behind this choice: that the market will gain 8% per year (which, on average, it does).
Pros: Convenient, quick
Cons: Expensive, assumes market will go up
Dollar-Cost Averaging
The idea here is to take a set amount of money and invest it throughout the year. The theory is much more robust than that, but the idea is that you ride out any huge changes in the market this way. If things go up during the year, you’ve been putting money in the whole time, so you’ve done well. If the market goes down, then you’re buying stock the whole way down and getting a lot of it on the cheap, so you’re doing well too. This is obviously the conservative, safe approach—which for a lot of people is the way to go when you’re dealing inside your retirement account.
The bad thing about this is that you have to take action several times a year, which isn’t the most convenient thing.
Pros: Rides out any ups and downs, “safer”
Cons: Requires several actions per year, won’t grow as much on an up market
My Take
I’m a huge fan of dollar-cost averaging in general, so that’s the side I’m on. It’s also a better fit for me because I’m a micromanager—I check my accounts all the time and this gives me something to do throughout the year, especially when the market is down. When that happens, investors psychologically feel like they have to do something. I’m in this camp, and with my obsessiveness it’s a natural fit.
It also helps me stay true to my allocation throughout the year. Every time I put more money in, I can contribute between all my investments to make sure none is growing or dropping faster than the others and my allocation stays where I want it to.
The reason I’m bringing this up now is because I just sent in Round 2 of my Roth contributions this year. The market has been down and right now I’m buying low. Right away I was reminded of this discussion and it hit me: if I had put all my money in back in January I’d be screwed. I wouldn’t be able to do anything right now.
What side do you fall on? Let’s start a nice, clean argument here…
Well, even one lump sum annually is a form of dollar cost averaging. Just at longer intervals. Since the Roth has an annual limit, it forces that…probably a good thing.
I’d say that if I had the money right up front, I’d put it in then. Otherwise I’d plan it out in segments over the year.
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