Financial Mistake #4: Dreaming of Tax-Free Gains in my Roth IRA

It’s been awhile boys and girls since the self-proclaimed not FI guru Q-FI has let down his guard and jumped into his world-famous walk of shame – financial mistakes segment. 

So here we go, up to #4 – dreaming of tax-free gains in my Roth IRA. 

This post is different than my previous financial mistakes post, “Financial Mistakes #3: Chasing Gains with Individual Stocks”, in which I detail some of my biggest investment losses over the years, because today I am reviewing the reasons why I was picking exceptionally high-risk stocks specifically in my Roth IRA account.  Two things were on my mind: BIG dividends and RISKY tax-free reward.  And although hindsight is 20/20, I wish I would have paid more attention to the risk management side of things rather than seeing stars with the tax-free gains I was dreaming of raking in. 

Although a Roth IRA is one of the best investment vehicles for tax sheltering purposes, rarely is it discussed that this sword cuts both ways – if you have heavy losses in this account, there is no tax loss harvesting advantage. 

My actual mistake in a broad sense, which I am sure every stock picker has struggled with over the years at some point, was being overconfident and not researching my investments well enough.  It’s human nature to believe you are better at something than you truly are, and Mr. Market has proven no exception to this rule.  But when you narrow down my misjudgment, my fatal mistake lies in only realizing the upside of my Roth IRA and ignoring the downside. 

Why I am being particular about my Roth IRA, is that if you have losses in this account, you cannot deduct them on your taxes or use them to offset capital gains as you can with a taxable brokerage account.  Most investors will say, of course Q-FI, duh!  Everybody knows this, and I did too.  However, being young and arrogant, I was more preoccupied with saving taxes on my potential gains (because of course I was smarter than everyone else and all it takes is just a little bit of time and effort to always beat the market, right?) rather than focusing on the potential negative consequences. 

Because as an inexperienced and cocky investor, I had a vision… a vision of my crafty intelligence making moves and day-trading my way to an investing paradise floating in the sky, paved in roads of gold and rivers overflowing with cash.  Let the government give me a tax-free account baby, and I’m going to make it rain!  Ha!  Like any novice, I assumed that I would be hitting way more home runs with my superior stock picking ability than strike outs.  And luckily for me, after more than 15 years the results are in: my Roth IRA account has not beaten the market over that time period while my taxable brokerage has.  And the two largest factors for this were: #1 the less risky stocks I picked and #2 being able to lock in capital losses in my taxable brokerage account. 

Time to fit in my quick disclaimer – this article is not giving investment advice and as you can tell from the title of this post “Financial Mistakes”, why would you even interpret it that way???  And for all the stock lovers, I’ve said numerous times before but I’ll say it again: I am pro stocks (that’s in favor of owning stocks, not implying I am a “pro” at picking them… haha).  I own them and will always own them.  But where I have gotten into past trouble, is being a little too greedy and paying more attention to the risky reward vs the downside of heavy and permanent losses. 

So let’s begin on the dividend/value side of things.  What went wrong in my Roth?  It’s pretty simple, instead of being satisfied with stable and consistent dividends in the 3-5% range, I needed 7-10% range to satisfy me (I’m a big shot here, no paltry returns allowed!).  Sure, these were riskier companies, but those extra percentages and the tax savings were well worth the risk, right? 

And, well, you can already see where this is headed, those high payers could not keep up those generous payouts over time, hence, why they got suckers like me to buy their stock and keep them funded while they burned through cash.  Then, when times were tight and they finally cut the dividend, that company usually went under rather than turning into a stellar value play.  If this investment was in my taxable brokerage, then no problem.  I lock in the losses and either offset some of my current capital gains or deduct it on my taxes.  But in my Roth IRA account, I’m just stuck holding the loser like the chump that I am. 

So what’s my takeaway on dividend/value stocks?  If you’re in it for the long haul, take the safer more stable bet.  If you understand the risk and are more short-term, take the time to really understand what you are buying.  Always thoroughly assess the risk you are taking on and pick the best investment vehicle (tax/non-taxable) to match your appropriate strategy (and if you don’t have a strategy, you probably shouldn’t be stock picking in the first place). 

Now onto the stock picking/growth side of things.  Back in the day when I was first researching which equities to buy in my Roth IRA, I mostly picked small-cap stocks that had the highest potential for growth.  In my mind, I wanted the quickest buck and fastest returns possible because time was on my side, which translated to… enormous potential with the shackles of herculean risk.  I was seeing stars and dreaming big again.  However, as we all know, this short-sighted strategy is great if it’s in a taxable account and you can deduct the losses if you’re wrong, but leaves you hanging high and dry if implemented in a Roth. 

The type of investment vehicle (taxable/non-taxable) can be just as important as the underlying asset class selected.  Do your research and pick wisely. 

Most investors already know this and take it into account.  I thought I did too at a young age, but it was easier for me to get preoccupied with fantasizing about the upside rather than thoroughly vetting the downside. 

And I don’t want to paint the picture that my Roth IRA was all doom and gloom.  I still did well overall.  I hit some amazing home runs while at the same time I also endured some painful strikeouts that cost me too.  However, my biggest lesson learned was that over a 15+ period I did not beat the market in this account.  With my big winners, I sure felt like I had beaten the market, but when all the losses were factored in, those aggressive losers weighed me down more than I had realized at the time.  So the irony is, after all those years of strategic plays and hedging portfolios, I could have just bought an index fund.  Hahahaha. 

But no problem and lessons learned.  And of course, there are a million caveats to my mistakes and suggestions above.  Every investing strategy is individual and based on a person’s unique situation, goals and risk tolerance.  So if you’ve been killing the market and accumulated way better results over the years in your Roth IRA, that’s great.  But if you’re on a newer track, hopefully you gleaned something useful from my aggressive and non-strategic use of my Roth IRA in my early years that can help you better plan for your own future.  

And hey, sometimes taking the safer route, isn’t a bad thing.  But it all depends on your long-term goals.  So, use that Roth account wisely my friends… 

-Q-FI 

P.S.  Do you change strategies based on taxable/non-taxable accounts or do you treat these investment vehicles the same?  How often do you evaluate assets based on a Roth vs. a normal account?