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Roth IRA: The benefits and why you need to start one now

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A Roth IRA is the best tax-advantaged retirement and investing account you can make. There are numerous benefits for young and old investors. Now for my military folk, don’t get a Roth IRA confused with the Roth TSP – similar features and benefits, but they’re completely different investment vehicles. It doesn’t mean you can’t contribute to both – and you should! 

Benefits of a Roth IRA

A Roth IRA is an investment account that allows your money to grow tax-free. Your contributions are after-tax dollars, meaning you’ve already paid taxes on the money you put into it. Unlike a traditional 401(k) such as the Traditional TSP, your taxes aren’t deferred. You pay taxes upfront, however, your account grows tax-free and when you withdraw at retirement, you pay no taxes. That’s right – every penny goes straight in your pocket without Uncle Sam touching it. 

There are numerous benefits to a Roth IRA, but I will only focus on a few, otherwise, this post might turn into a book! Some of the benefits of a Roth IRA include:

  • Tax-free growth
  • You can withdraw early
  • Not forced to withdraw
  • Most people can start one
  • Dividends are your friend
  • Backdoor entry

Let’s get started!

Tax-free growth

If you’re confused by “after-tax” dollars, it means that taxes from earned income have already been taken out. For a traditional 401(k), individuals can elect to have a part of their paycheck automatically deposited into their investment before taxes are taken out. This provides two advantages. Your taxable income is lower, which can move you into a lower tax bracket. And, you only pay taxes when you withdraw from your retirement account.

However, this can be disadvantageous because you might be in a higher tax bracket when you withdraw. This is one topic that has started many wars among investment experts. Pay taxes now, or defer them. They both have their advantages. Now, onward!  

As I mentioned, your money grows tax-free, compounding every year. The annual contribution limit for 2020 is $6,000, or $7,000 if you’re age 50 or older, per IRS Contribution Limits. For high-income earners, your modified adjusted gross income can’t exceed $124,000, or married folks filing jointly can’t exceed $196,000. But as I will explain later, there’s a back-door opportunity for high-income earners.

Now, why do you need to start a Roth IRA now? I am going to let the chart tell you why…

roth ira benefits

As you can see, someone who started investing $5,500 at the age of 25 and only contributed for 10 years for a total of $55,000 – had a larger total value by the age of 65 than someone who started at the age of 35 and invested $5,500 every year for 30 years. What you see is the power of compounding! Pretty compelling evidence that the sooner you start, the “more better.”

You can withdraw early

One least known fact, or at least less talked about, is the fact you can withdraw contributions early. You can withdraw your contributions anytime, without penalty because you already paid taxes on them. Now don’t get this confused with your earnings. Earnings cannot be touched until you’re 59 1/2 years old – but there are a few exceptions:

  • You’re withdrawing up to $10,000 to buy your first home.
  • You’re withdrawing up to $5,000 in the year after the birth or adoption of your child.
  • The withdrawal is for qualified education expenses.
  • The withdrawal is for un-reimbursed medical expenses in excess of 7.5% of your adjusted gross income for the year.
  • The withdrawal is for health insurance premiums while you’re unemployed.
  • The withdrawal is due to disability.
  • The withdrawal is made to a beneficiary or your estate after your death.
  • You decide to take substantially equal payments, which basically locks you into taking at least one distribution per year for at least five years or until you turn 59½, whichever comes last.
  • The withdrawal is due to an IRS levy.
  • You made the withdrawal when you were a reservist, as defined by the IRS.

That is a long laundry list of exceptions! That is one of the many reasons why I believe a Roth IRA is one of the best investment accounts you can own. If you need money you can withdraw it, unlike a traditional IRA that requires it be a loan.

I also recommend parents thinking about funding college with a 529 Plan, look at a Roth IRA first. 529 Plans are fantastic investment vehicles for college expenses, but only for that. If you’re unsure if your child will attend college, a Roth IRA gives you flexibility. They can use it for qualified college expenses, or as a down payment for a house. Even better, they can let it continue to grow, funding their retirement.

Not forced to withdraw

Money in a traditional IRA is subject to “required minimum distributions”, otherwise known as RMDs. What does that mean? Investors are required to start withdrawing from their accounts at age 70 1/2. Forget to withdraw and the IRS will hit you with a devastating 50% penalty excise tax on the amount you didn’t withdraw. Ouch!

Roth IRAs are RMD-free. Account-holders are free to let their money nestle in for as long as they’re alive. This allows your investment to continue to grow tax-free. Also, you avoid selling assets at a bad time. In a traditional IRA, forced withdrawals mean cashing out investments regardless of market conditions. In a down market year – *cough* 2009 *cough* – that could mean selling at a loss. No thanks.

Most people can start one

A majority of the U.S. population can start a Roth IRA, even kids – though by a custodian. High-earners are prohibited from contributing, but as I will discuss later, they can utilize a “backdoor” method. But what about spouses who don’t have any earned income? Yes, they can start one as well!

You and your spouse can each start a Roth IRA as long as one of you earns eligible compensation that is twice the contribution amount. So for the year 2020, one spouse must have eligible compensation of $12,000, or $14,000 if both are over 50 for the $1,000 make-up contribution. The Roth IRA accounts cannot be created jointly, nor will any investment platform give you that option, and must be made separately. It’s a fantastic opportunity for the non-working spouse to build retirement savings.

As I mentioned earlier, I recommend parents looking at funding their child’s college expenses via a Roth IRA, vice a 529 plan. But, how does one start a Roth IRA for a child? Custodian accounts! A majority of investment platforms offer custodial Roth IRA accounts. Individuals under the age of 18 are not allowed to open brokerage accounts, so their parents or custodian must do it for them. To legally contribute to a custodial Roth IRA – your child, regardless of age, must have earned income. 

What constitutes “earned income?” The IRS defines it as “all the taxable income and wages you get from working…for someone who pays you or in a business you own.” Mowing lawns or babysitting can count – you just need to properly document it. Another perk – if your child spends all the money they earn, you can contribute on their behalf — as long as you don’t exceed the amount of their annual earnings.

Dividends are your friend

For the year 2020, contributions are capped at $6,000 unless you’re 50+ years old, you can contribute an additional $1,000. Just because your contributions are capped, doesn’t mean you can’t have stocks exceed your contributions through dividends. Hmm, what are you sayin’?

Dividends earned in your Roth IRA do not count towards your contribution limits. So, let’s say you max out your Roth IRA this year on January 1st, the very first day you can. If your portfolio consists of ETFs, mutual funds or stocks that pay dividends – those dividends can be reinvested tax-free and won’t exceed your annual limits. Dividends are the King of passive income, for that reason alone. 

My Roth IRA portfolio consists of growth stocks and those that pay dividends. This year alone, I am projected to reinvest $6,489 in dividends – on top of the $6,000 I already contributed. Pretty neat, right?

> Want to start a Roth IRA? Learn how.

Backdoor entry

Basically, a backdoor Roth IRA boils down to some administrative shuffling. You put money in a traditional IRA, convert the account to a Roth IRA, pay some taxes and you’re done. Even though you didn’t qualify due to income restrictions – essentially, you weren’t invited, but that won’t stop you – you skipped around to the backyard and entered through the backdoor. Boom! Now you can enjoy the party. 

Since only post-tax dollars go into Roth IRAs – you must deduct taxes from your traditional IRA contributions. But don’t worry, the government will do it for you when you file your taxes. It will count as income – so, you will need to work with your financial planner to determine how much you should backdoor to stay within a certain tax bracket. You can backdoor once a year – so you can spread the tax hit every year until you completely convert your traditional IRA over.  

Final Thoughts

Hopefully, you’re already scrambling to find an online brokerage to start your Roth IRA. Or, if you already have one – learned something new, like the early withdraw perk. This seems to be the most common unknown or less realized benefit. I use M1 Finance as our platform for our Roth IRAs. It’s free and easy to use. 

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