Looking into retiring comfortably? Look into Roth IRA

Many people, especially people in their 20s and 30s, consider retirement so far away that they prefer not to even think about it. What people don't realize is that the sooner you start thinking about retirement, the more money you will have to retire with.

There are a couple of different investment accounts that the United States Government makes available to people to help them retire with a substantial amount of money.

A traditional IRA is an individual retirement account that uses pre-taxed income from your job to deposit into an account that is then invested in various assets that compound overtime to make a substantial amount of money set aside for you when you retire.

A Roth IRA is very similar to a traditional IRA except that it has a few different rules and it uses income from your job that has already been taxed.

Photo by Frederick Warren

What is a Roth IRA?

The point of a Roth IRA is that it's basically an individual retirement account that has special tax benefits. It's kind of a loophole that the government gives people to help them retire.

The money can't be touched by the IRS, because that would be double taxing which is illegal. Roths are essentially tax-free money for when you retire.

What You Need to Know

The IRS has rules for the Roth IRA which determines how it can be used and who it can be used by. You can have any type of investment inside of a Roth such as stocks, bonds, mutual funds, gold, real estate, any type of appreciating asset is best. The options of assets that you could use to invest in Roths are unlimited.

As of this writing, you can put in $6,000 per year if you are under 50 and $7,000 if you're over 50. If your household income is above $144,000 as a single or $214,000 as a married couple, you can't contribute to a Roth IRA. This is mostly a plan for middle-class people to retire. If your income is less than the $6,000 limit, then you can only contribute up to what you made, so if you only made $3250 in 2021, then the max amount you could contribute to your Roth is $3250. 

If you go over $6,000 you have to pay a 6% excise tax which would kind of defeat the purpose of having a Roth. You can get a wealth manager that will stop you from going over and having to pay the tax which could be a great help.

If you already have a 401k or a traditional IRA you can still contribute to a Roth account. If your company does not offer a 401k then a Roth account becomes much more important, because it may be your only chance at retirement. You never have to take money out of a Roth account if you don't want to, compared to a traditional retirement account that makes you start withdrawing at age 72.

With a Roth account, you can withdraw the money whenever you want as long as the account is over 5 years old and you are at least 59.5 years old, so you can wait until 100 years old if you want or you could pass it down to your children. It's never too late to open a Roth account.

If you or your spouse is not working they can still open a Roth account, but the IRS will set the rules according to the working partner's income.

After 5 years of your first deposit, you can withdraw your money at any time. The point is to wait until retirement, but sometimes things come up and you need to withdraw. If you try to withdraw within the first 5 years you'll have to pay a penalty when you withdraw.

Benefits of a Roth IRA

A Roth IRA has tax-free withdrawals as long as you meet the requirements. The reason the money is not taxed is because the government has already taxed you when you got paid from your job.

A Roth account grows and grows exponentially due to compound interest from your initial investment from depositing your money each year and the profits from that money being invested into assets.

A Roth IRA creates significant tax savings over the course of your lifetime. The main difference between the two types of retirement accounts is that Roth IRAs have tax-free withdrawals and traditional ira has taxed withdrawals.

For example, with a Roth account, if you're in a 20% tax bracket when you open your account at age 20, when you are 59.5, and in a 40% tax bracket you don't have to pay taxes when you withdraw the money

With a traditional IRA, in that same scenario when you withdraw your money the IRS will tax you 40% of the money that you withdraw.

So you saved money by investing in your ira for the years that you invested in your Roth account at the 20% tax bracket.

There's flexible timing involved with a Roth IRA so a year is actually 16.5 months instead of 12. If you open an account on February 4, 2022, you have until June 9, 2023, to invest your $6,000 for the year.

You can invest all $6,000 at once or you can invest once per month or every two weeks or once a week. You can spread the $6,000 limit over the 16 months however you want.

Additional Rules

You can open an IRA at any age as long as you can prove that you earned income. Some states allow you to start working as young as 15 1/2 years old, so if you have a job you can start at a very young age and have a tremendous opportunity to build a substantial amount of compounding interest. If you start at 15 1/2 years old and invested $6,000 per year in your Roth IRA you'll have a substantial amount of money to withdraw by 59 1/2.

You can withdraw the principal balance from your Roth IRA at any time after 5 years from when you started the account. The principal balance is how much you actually contribute to your Roth IRA minus the profits that were made from its investments. You don't have to pay taxes on it because that money was already taxed when you earned the money from your job and then put it into the Roth IRA.

If you want the full balance then you have to pay taxes on the profits that were made from investments if you are not yet 59.5 years old. If you only withdraw the principal balance and leave the profits from investments in your Roth they will continue to increase in value and compound interest.

You have to be over 59.5 in age and your account has to be active for over 5 years in order to withdraw everything from your Roth IRA account without paying taxes on the profits from investments.

Things to Be Aware of

Make sure that you're actually using your Roth IRA every year. Deposit the full limit the government has set for the year into your Roth so that you can maximize your withdrawal amount later. Your future self will thank you.

You don't want to be 59 years old wishing you invested in a Roth account. You know now, take action now!

It's not a guarantee that you will become rich from your Roth account. The things you invest in could later depreciate, the stock market could crash, your house can catch on fire. In many cases, people do well long-term with Roths, but again, it's not a guarantee.

Make a large effort not to take your money out of your Roth IRA early, and if you do put it back before the year is over. The compound interest that you could lose for just missing one year of potential investing could cost you hundreds of thousands in the long term. 

Build an emergency fund on the side of your Roth account so you can use that in case of an emergency. Your retirement fund should be for retirement only.

CONCLUSION

So is it worth it to invest in a Roth IRA? If you want to get a tax break now then get a traditional IRA because you invest in it with pre-taxed money. This is good for people that will be in the same tax bracket until they retire.

If you plan to be in higher tax brackets when you retire, then you should get a Roth IRA right now so you can save on paying taxes on your deposits into your Roth while you're in a lower tax bracket, then withdraw the money tax-free when you retire.

Young people would have a big advantage by getting a Roth right now, because people typically start in a low tax bracket when they are young, and then make more money as they get older which puts them in a higher tax bracket by the time they retire.

Because of compound interest, you will make more money the sooner you open your account.

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