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An Active Roth IRA Strategy for Value Investors

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

Investing via a Roth IRA can be a good long-term strategy tax-wise.

Investing via a Roth IRA can be a good long-term strategy tax-wise.

Profits and Taxes

As a value investor, I've long been a tremendous fan of the concept of Warren Buffett's famous favorite holding period: forever. This means paying attention to what the business is doing but not what the stock price is doing—other than allowing Mr. Market to serve you with a very good price.

This strategy not only presents the opportunity for terrific returns over a longer time horizon, but it also can save you a tremendous amount of money in capital gains taxes. This means that buying and holding for the long term is a wonderful way to compound wealth over time (and doubly so since the IRS penalizes activity when selling).

The short-term capital gains rate is much higher than the long-term rate, meaning that if you sell a stock less than a year after buying it, your returns are very likely to be significantly reduced. A Roth IRA offers you a way to circumvent this, and if you have a solid strategy (and enjoy picking stocks), you may be able to use the following method to great success.

The Myth of Compounding

Einstein probably never said that "compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn't pays it.” Nevertheless, understanding the power of compounding is essential for any investor. Your money goes off and has little baby moneys, and then the babies reproduce again, creating more wealth. If you receive dividends from a stock and reinvest into the stock, that means you own more of the company, and if a company reinvests its profits into itself, the end result can be even better since you wouldn't be taxed on dividend payments. This is all completely true and absolutely essential for anyone who owns stocks to grasp on a deep level.

However, there is a pervasive myth among value investors about what this really means. The idea that if you buy and hold a stock forever, you're reaping this amazing "eighth wonder" by allowing your wealth to compound over time is absolutely true. But the corollary—that if you sell your stock sooner than "forever," you are giving up the ability to compound—isn't necessarily true.

Imagine a hypothetical scenario in which you find an amazing company you're really confident in, and so you buy the stock for $100 today. Since it's a great company, over the next five years, your principal (the amount you initially invested) doubles. Doubling your money over five years is not bad at all! Now imagine that you sold the stock when it jumped up 40% after the first six months of you owning it. Didn't you make a mistake by giving up the 100% in profit?

Not necessarily, assuming you didn't simply take your profits and then hide your money under your mattress for the next four and a half years. Instead, imagine that you took your 40% gains and your original principal back to work almost immediately, finding another stock that goes up 40% in six months, and so on. After five years, your principal wouldn't be worth $300; it would now be worth $2892.

Are You Buffett or Lynch?

The question you need to ask yourself, then, is whether you're better at picking up cigar butts, as Ben Graham lovingly called them, or individual great companies at the rate of one every few years. There's not a right or wrong answer here, and you're likely to have to do some experimenting, approaching your investing strategy just like a scientist would.

Peter Lynch's Magellan Fund returned an incredible 29% per year for well over a decade, an absolutely astounding record. Unlike Buffett, who often had as few as three investments at a given time with BPL (Buffetf Partnership Limited, his investment company before Berkshire), or Charlie Munger, who managed a grand total of five stocks in 2021 in his Daily Journal portfolio, Lynch owned dozens of stocks.

Neither strategy is right or wrong, and both can be value-investing strategies as long as you believe the underlying business will produce earnings over time that are much higher than the stock price indicates (after all, a stock is just a piece of a business). This is a question you'll want to answer for yourself. To paraphrase Buffett, do you want to have a single significant other, or would you rather have a harem?

But the Taxman Cometh

Let's revisit our compounding example from earlier but consider taxes. Short-term capital gains (the "profit" you make when you sell a stock after owning it for less than a year) are taxed at the same rate as your income, and that can vary quite a bit depending on your tax bracket, but let's assume that you pay 25% for short term gains and 15% for long term gains. If you pay taxes at the end of every year on what you gain (40% every six months), your end result is more like $700 instead of nearly $3000.

Compounding can be a double-edged sword when taxes come into play, and you have to be careful to consider whether it's still worth it to be so active. In the example we used, it certainly still is, since $700 is a great deal more than $300 (your "buy and hold" result). Further, if you were to sell your security after a five-year holding period, you'd still need to pay 15% on those gains, reducing your overall principal to $255.

It's important that you don't let the tail wag the dog with regard to your strategy, and avoiding paying taxes shouldn't ever be your primary objective. Instead, seeking to maximize your after-tax return is a much better goal. Even after paying much, much more in taxes, the Lynch garden-tending strategy of more frequent selling is the clear winner in our example.

That being the case, wouldn't it be nice not to have to eat into your profits at all? The US government actually does offer a pretty good solution to this dilemma, at least in part: the Roth IRA. The way this account works is that the money you invest is after-tax, meaning you've already paid the tax on your initial principal.

In our $100 example, you've already paid $25 in tax before you invest it into the Roth. This means the compounding can take hold on its own, uninterrupted, and you will never have to pay any taxes in the future on your capital gains. There's a pretty big caveat: you can't withdraw the money earlier than a particular age. Investopedia describes these stipulations quite well:

  • You can always withdraw the money you contributed with no tax or penalty.
  • If you’re over 59½ and your account is at least five years old, you can withdraw contributions and earnings with no tax or penalty.
  • For those who are under 59½ or don't meet the 5-year rule, special exceptions apply to first-time home purchases, college expenses, and several other situations.

Using the Roth

If you can live with the terms of the Roth IRA, then you may be able to take full advantage of the opportunities presented therein. Allowing your money to grow over time—whether through a buy and hold strategy or from a much more active approach—is the key to the investing castle.

Determining whether you're a Lynch or a Buffett is something you'll need to decide for yourself, since both strategies can work extremely well over time, and you might as well experiment with both strategies inside your Roth when you first get started. Over time, and without paying any taxes, you can determine which approach works best for your total return, and then you can take the reigns without fear.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.