What is a Roth IRA?
A Roth IRA is a retirement account one can use to save for retirement. However, it is more than a retirement account.
It is a powerful wealth building and income tool.
Whatever you contribute (put into) the Roth IRA grows tax-deferred and, as long as you meet certain requirements, when you pull money out of your Roth IRA the funds will be tax-free. These are called qualified distributions.
The requirements that need to be met in order to get tax-free withdrawals (qualified distributions) are that the Roth IRA needs to be opened for 5 years and you need to be at least age 59 1/2.
If you meet those two requirements, when you pull money out of the Roth IRA the withdrawal will not be taxable.
Now, contributions to a Roth IRA are not tax deductible (in contrast to Traditional IRAs) and you already paid tax on whatever you put into the Roth IRA, so what is really tax-free are the earnings on the Roth IRA contributions.
With that being the case it makes the most sense to grow the assets in your Roth IRA as much as possible, so you take full advantage of the tax-free withdrawal of the earnings.
Now, since the earnings are tax-free the IRS has set some guidelines and rules as to who can contribute to a Roth IRA and how much you can contribute.
As of the time of this writing in 2022, the maximum contribution limit to a Roth IRA is $6,000. If you are over age 50, you can contribute an additional $1,000 for a total contribution limit of $7,000.
This amount is adjusted each year for inflation, according to the IRS.
Also, there are income limits for who can contribute to a Roth IRA, meaning if you make above a certain amount of income you are not allowed to contribute to a Roth IRA.
Currently, for married couples filling taxes jointly, if you make under $204,000 (Modified Adjusted Gross Income) you can contribute the full amount of $6,000 ($7,000 if over age 50). If your income is over $214,000 then you can’t contribute at all. If you fall between $204,000 and $214,000 then you can contribute a reduced amount.
If you are a single filing taxpayer, if you make less than $129,000 (Modified Adjusted Gross Income) then you can contribute the maximum of $6,000 ($7,000 if over age 50). If you make more than $144,000 then you can’t contribute at all. If your income is between $129,000 and $144,000 then you can contribute a reduced amount.
Now let’s talk about some of the intricacies of a Roth IRA that makes them such a powerful tool for building and managing wealth.
There is the obvious…the earnings are tax-free. That’s great. With all the government spending going on, social programs, etc. tax rates may be higher in the future so having access to tax-free IRA withdrawals can be powerful.
However, Roth IRAs also have no RMD requirement (in contrast to Traditional IRAs). This means that if you don’t need to take out any money in a given year you don’t have to. You can leave the money in the IRA and let it continue to grow…as long as you need to. This makes the Roth IRA a powerful wealth building tool and estate planning tool. If there is someone that you care about and want to leave some assets to, a Roth IRA might be something to consider.
Also, Roth IRAs are flexible.
If you find yourself in an emergency and need to access some funds to cover an expense you may want to consider looking at your Roth IRA.
There is something called the “withdrawal ordering rules” with Roth IRAs.
Essentially, when you make a withdrawal the IRS categorizes the withdrawals in this order…
contributions, conversions and earnings.
This means that contributions are considered to have come out first, then any money you have converted from your Traditional IRA to your Roth IRA and lastly, the earnings.
This ordering rule is important if you are under age 59 1/2.
The important thing to remember here is that you can access the contributions in your Roth IRA anytime before age 59 1/2 tax-free and penalty free!
Since the contributions have already been taxed (remember non-tax deductible) you can pull them out of the IRA tax-free and penalty free if you need.
Now, ideally you don’t want to pull any money out before age 59 1/2 but it is nice to have the option.
There are other reasons that you can withdrawal from your Roth IRA without paying a 10% IRS penalty but actually pay income tax on the earnings, and these would be non-qualified distributions, and can include reasons like being a first time homebuyer, paying medical insurance premiums after losing your job, etc.
There are many features, benefits and intricacies of Roth IRAs and they can be a great tool for building and managing wealth. And when you are early in your career and you can contribute to a Roth IRA, it is important to considering taking advantage of a Roth IRA.
Work with your advisor and see if a Roth IRA makes sense for you and if you should consider one.