How does a Roth IRA work?
You’re here learning about lots of different retirement accounts, and now you’ve stumbled across the Roth IRA, the one most people get excited about.
I’m here to simplify everything you need to know and clear up any misconceptions you may have about the Roth IRA.
The Roth IRA is an Individual Retirement Account that you can contribute money to every single year for retirement.
Money Restriction: As of 2020, those under the age of 50 can contribute up to $6,000 per year and those 50 and above can contribute up to $7,000 per year.
Age Restriction: Once the money is put into this account, you cannot withdraw it until you are 59.5 years old. Unlike 401k and like HSAs, you are not forced to take distributions (withdrawals) when you turn 70.5 years old (Required Minimum Distributions).
Penalty: There are many withdrawal rules that make Roth IRAs so exciting. The IRS really only cares about two things:
- The 5-year rule: if you’ve had five tax years after your first Roth IRA contribution
- If you’re under 59.5 years old
Here are the withdrawal rules:
- You can always withdraw the amount you contribute from a Roth IRA (almost like an emergency fund)
- If you’re under 59.5, the money will be taxed as income and penalized 10%
- You can avoid the penalty if the money is used for a first-time home purchase, if you’re permanently disabled, or if a beneficiary takes the distribution
- You can also avoid the income tax if you meet the 5-year rule
- If you’re over 59.5, you will not be penalized for any withdrawals
- You can avoid the income tax if you meet the 5-year rule
In any other situation, if you withdraw funds, that money will be taxed as ordinary income and the IRS will impose a 10% penalty.
Tax-Advantage: The Roth IRA is what is known as a tax-advantaged account.
There are 3 ways you can obtain tax benefits in any investment account:
- When you put money in
- When your money grows
- When you take money out
The Roth IRA takes advantage of numbers 2 and 3.
- Taxed Contributions: the money you place in your account is already taxed (post-tax money)
- Tax-Free Growth: gains from investment growth, dividend payouts, and accumulated interest are not taxed
- Tax-Free Withdrawals: distributions, or funds you withdraw, are not taxed
- Roth IRA = Roth Individual Retirement Account
- Can only withdraw money after 59.5 (within the rules)
- Can take out whatever you put in
- Under 50 Contribution Limit: $6,000/yr
- 50 and over Contribution Limit: $7,000/yr
- Tax-free growth and withdrawals
In order to be eligible for a Roth IRA, you simply need earned, taxable income. But not too much.
You cannot contribute if you are too rich. As of 2020, singles making an income of $139,000 per year and families making $206,000 per year cannot contribute to a Roth IRA.
- Have taxable income in order to invest
- But not too much
- That’s about it
Other Things To Know
1. Don’t Miss Out on the Tax Savings
Let’s say I started maxing out my Roth IRA at $6,000 every year.
After 40 years, I would have $1,280,000 dollars in my Roth IRA if I invested it in the S&P 500 (average 7% annual return).
If I invested that same money into a taxable brokerage account, I would have $822,000 in that account.
I saved ~$457,000 in taxes. That is mind-blowing. That is also why you should start investing in a Roth IRA today.
2. High-Income Earners Are Not Hopeless
You’re not out of luck if you make a lot of money.
Be sure to read up on Backdoor Roth IRAs in order to maneuver your way around the income limits.
3. Diversify Your Assets
When people think of diversification, they often think about investing in different funds, which is important.
You never want to put all your eggs in one basket. Don’t use all your money to buy a single stock, but perhaps buy index funds that track the entire market or follow the three-fund portfolio.
That being said, having a Roth IRA be your only investment means that if you retire when the stock market is down, then you gotta wait years for it to get back up, delaying your retirement.
Be sure to diversify your assets (e.g. real estate, savings accounts, CDs, cash, Roth IRA, etc.)
The Roth IRA is available to most of us in the USA, which is why it recently blew up in popularity. It’s a great investment account and will let you grow your money in the long run.
Just make sure you understand what you’re investing in, and continue to spread out your investments so that you’re all set for the future.
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