Roth individual retirement accounts allow you to stash after-tax dollars in a special account where the money grows tax-free; all of it – including the earnings – could potentially come out tax-free at retirement. When deciding how to make contributions, many people either make one big contribution at the start of the year or spread their contributions over the course of the year.
Read More: Can a Large Sum be put into a Roth IRA?
Monthly Contribution Advantages
When you're making out your budget, having to account for a $6,000 expense ($7,000 over age 50) – the maximum 2021 Roth IRA contribution – can be quite a shock to your system, and in some cases so disheartening that you might not think it's possible to save for retirement. However, when you break it down to a monthly expense, you can fully fund your Roth IRA for the year for just $500 per month.
In addition, funding your Roth IRA monthly rather than annually allows you to take advantage of dollar-cost averaging, which refers to buying smaller amounts of stock multiple times per year rather than in one lump sum. Stock prices fluctuate, so dollar-cost averaging helps hedge your bets against a huge price drop because if the prices do decline after the first month, you get to buy additional shares the second month at the lower price.
Monthly Contribution Disadvantages
The biggest downside to spreading your contribution over the course of the year is that you're delaying taking advantage of the tax-sheltered growth offered by Roth IRAs. If you have the cash to make the contribution sitting in an interest-bearing account, that interest counts as taxable income. If you put the money in the Roth IRA, any future earnings aren't taxed as long as the money stays in the account, and if you take a qualified Roth IRA distribution, it won't ever be taxed.
Roth IRA Lump Sum Advantages
If you make one lump sum deposit into your Roth IRA, you can be done for the year – no worrying about putting the money in each month or being tempted to spend the money elsewhere. The sooner you put the money in your Roth IRA, the sooner it starts growing tax-free, and assuming you wait until you can take qualified distributions, those additional earnings also come out tax-free.
To take a qualified Roth IRA withdrawal, you must have had a Roth IRA for at least five years and you must be either 59 1/2, permanently disabled, taking distributions as a beneficiary or taking out up to $10,000 as a first-time home buyer.
Lump Sum Disadvantages
Of course, making one lump sum contribution could also come back to bite you if your investments take a tumble shortly after you contribute. In addition, if you make the lump sum contribution at the start of the year, you could find yourself short on cash later in the year and have to take a distribution. Though you won't owe any early withdrawal penalties or taxes as long as you don't take out more than you've contributed, you can't contribute extra in future years to make up for the money you took out.
Read More: How Much Will a Roth IRA Lower my Taxes?
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."