The Roth IRA may be the most potent financial account ever created.
Imagine having the ability to invest in practically any type of asset you want… and when you take profits from that investment, there are ZERO taxes.
Well, that’s EXACTLY what the Self-Directed Roth IRA does for you.
Here’s how it works…
You've probably heard of the Individual Retirement Account, the financial tool that the government gives us to save money for retirement in a tax-efficient manner.
But that tax efficiency is only on the front end. Basically, the standard IRA gives you tax breaks in the present day at the expense of potentially much higher taxes in the future.
For some people, that gamble works out. But if you're successful as an investor in your IRA, that gamble is going to cost you… big time.
That's where the Roth IRA comes into the picture. Putting money in a Roth IRA doesn't affect your present-day taxes at all…
…but when retirement comes, and you're making withdrawals from a Roth IRA, you get to enjoy something that's almost too good to be true: ZERO TAXES!
The IRS' View of Roth IRA's
It makes me laugh whenever I read the IRS' description of the Roth IRA. They describe it as
A Roth IRA is an IRA that, except as explained below, is subject to the rules that apply to a traditional IRA.
I laugh because that statement is both true and a ridiculous understatement of the overwhelming potency of the Roth IRA.
Why is it so potent?
Well, the reasons that, according to the IRS, the Roth IRA is different from the traditional IRA are as follows:
- You cannot deduct contributions to a Roth IRA
Well… nothing attractive about that.
- The account or annuity must be designated as a Roth IRA when it is set up.
So… there's more work to setting up a Roth IRA? Again, not attractive
- You can make contributions to your Roth IRA after you reach age 70 ½.
So I can continue saving for retirement while I'm in retirement. Ok… good, I guess…
- You can leave amounts in your Roth IRA as long as you live.
So there are no “required minimum distributions”? That's pretty nice…
So, all in all, some nice differences, but nothing that's really amazing. But then there's one other “little” difference:
- If you satisfy the requirements, qualified distributions are tax-free.
HOLY COW! Does that say that distributions (withdrawals) are tax-free?
Yes, that's what it says… and that's the big advantage to a Roth IRA versus it's traditional counterpart.
That's the difference that should be in big, bold letters across the top of the page there on the IRS' website… but then I remember: It's not their goal to minimize your tax burden, is it?
Roth IRA Eligibility
Roth IRA eligibility is very simple: If you earn an income, you qualify.
(Unless, of course, you earn more than $118,000 per year [as of 2017] or so… after all, the government wouldn't want to give good tax benefits to their biggest tax payers, now would they?)
Quick Note: If you make too much money to qualify for the Roth IRA, don't fret. You can still have one by using the “backdoor Roth IRA strategy”.
Unlike the Traditional IRA, there's not an age limit of 70 1/2. You can open and continue to contribute to a Roth IRA at any age.
Roth IRA Contribution Limits
For 2017, you can contribute up to $5,500 to a Roth IRA. If you're 50 or over, you can contribute an additional $1,000 per year.
In other words… it's identical to a Traditional IRA.
Roth IRA Withdrawals
Another nice feature of Roth IRA's is that you can withdraw money from it any time you want – even before retirement – without any penalties or taxes, as long as you don't withdraw more than you've contributed.
(This really isn't a gift from the IRS. The fact is that you've already paid taxes on every penny you put into a Roth IRA, so it stands to reason that those dollars wouldn't be subject to taxation upon withdrawal.)
Once you get to the point of withdrawing profit, then you'd have to pay tax and an early withdrawal penalty on that money if you're younger than 59 1/2. But if you're older than 59 1/2, you won't pay taxes on ANY of it!
Roth IRA's and Required Minimum Distributions
Required minimum distributions (RMD's) are a real pain for Traditional IRA owners.
The RMD is the way that the government forces you to take money out of your Traditional IRA so that they can tax it.
But there are no RMD's with Roth IRA's. Period. That's pretty sweet.
Converting from a Traditional to a Roth IRA
If you have money in a Traditional IRA and would like to have it in a Roth IRA instead, I've got good news and bad news.
First, the bad news: You're going to have to pay income tax on any money you transfer from a Traditional IRA to a Roth IRA. There's no way around that.
But the good news is: The IRS won't hit you for the normal 10% early withdrawal penalty, which you'd otherwise owe for withdrawing from an IRA (assuming you're younger than 59 1/2).
Who Should Use a Roth IRA?
This is a great question for your financial adviser, but I do want to dispel one common piece of advice that's very bad.
The conventional wisdom on this question is as follows:
- If you think your income tax rate will be lower in your retirement years than it is right now, then you should contribute to a Traditional IRA.
- If you think your tax rate will rise in your retirement years versus your current rate, then you should use a Roth IRA instead
I think that's terrible advice.
First, nobody knows what tax rates will be in the future. Anybody who suggests otherwise is lying to you.
Second, if you expect to withdraw precisely the same amount of money from your Roth IRA as you deposited to it, then the conventional wisdom may be reasonable. But if you expect to be successful as an investor, then chances are you'll be withdrawing – and paying taxes – on FAR MORE than you deposited in the first place.
This isn't a zero-sum game, even though the conventional wisdom treats it like that. Sure, you may pay a lower income tax rate during retirement, but if you're paying that rate on a much larger amount of money than you originally deposited, then that “lower rate” could still very easily cost you far more money in the long run.
Bottom Line on Roth IRA's
You can probably tell that I'm a fan of the Roth IRA (and it's cousin, the Roth 401k).
But as with everything else, it's wise for you to talk with a financial adviser who knows the specifics of your situation before making a decision about which type of account is best.
In fact, for the savviest of self-directed investors, the question is never “which” but “when”…