The Roth IRA – Live Tax Free
Introducing The Roth IRA
A little bit of background information
IRA stands for individual retirement account. IRA’s were created in order to incentivize saving for retirement. Basically, the US government decided that they would give you a little tax break if you decided to save for retirement instead of spending all your cash. In this article, I want to discuss a special kind of retirement account, the Roth IRA, in detail.
What the Roth really is
In all simplicity, a Roth IRA is just an account. It’s like all of your other accounts, be it a savings account, checking account, 401K, IRA, HSA, 403B, etc. (the list goes on and on). The only difference between the accounts are the rules. Playing around with different accounts is similar to playing different games. Should you choose to properly play the Roth game, you will find that it is a powerful, wealth-building account.
The Rules of the Roth
Since the Roth IRA was designed by the US government, there are a lot of arbitrary rules and regulations set in place. However, some of them may make sense if you keep in mind the intent behind the Roth IRA – which is to create an incentive for retirement saving.
Because the Roth allows you to grow your money tax free, the government loses out on significant tax revenue. In order to control this, they set rules as to if and how much you can contribute.
There is only one hard requirement to open and contribute to a Roth IRA:
In order to fully contribute to a Roth IRA the normal way (i.e. make an account and deposit cash using NO loopholes), you must have an annual income that is less than $118K if you are single, or less than $186K if you are married (and filing your taxes jointly).
After you start making more than the limits shown above, the government slowly lessens the amount you can contribute to your Roth IRA until it reaches 0. However, if you are wealthy and have an awesome income fear not, for the US is a country made by the wealthy, for the wealthy. There’s a loophole called the backdoor Roth IRA that you can use to contribute no matter what your income is. However, discussing that loophole involves discussing other financial accounts, which is beyond the scope of this post.
Here’s a graph of what the contribution limits have been since 1998 (data courtesy of investmenthunting.com):
Basically, what happens is that the government sets a limit, and then raises that limit every couple of years due to inflation. Right now, that limit is $5,500. What this means is that you can place up to $5,500 in your Roth IRA every year. Also, if you noticed, there is a different limit for people above age 50, lets talk about that.
The “catch-up” rule
Some people learn to be financially savvy later on in their life. In their early years they decide to save less and enjoy more. However, as retirement approaches, these people decide to start saving. In order to help these “late-bloomers” the US government allows people age 50 and above to contribute an extra $1000 per year to their Roth IRA. Thus, people above age 50 can place up to $6,500 per year into their Roth IRA’s.
The “earned income” rule
In addition to the limits discussed earlier, there is another contribution limit. Let’s say that you made a grand total of $500* this year. Well, you are only allowed to contribute the lesser of the following:
- what you earned ($500)
- $5,500 ($6,500 if you are allowed to catch-up).
*Money that you get “under the table” and did not pay taxes on doesn’t count as “physically earned”. To simplify this, if you paid income taxes on your money, it probably counts as “physically earned”.
When can I contribute?
It would make sense to think that you must contribute to your Roth in the same year that you want to contributions to count (i.e you can’t contribute $5,500 for the 2012 year in 2016). However, the US government set up a weird little loophole around this. You can contribute for the previous calendar year up to April of the current calendar year. Think of contributing to your Roth IRA like a homework assignment, the due date is right before new year’s eve! However, Uncle Sam is generous, and will allow you to turn in your Roth contribution up to ~3.5 months late (the hard deadline is April 17). If you’re still confused, look at the graphic below:
Typically, retirement accounts have heavy penalties if you withdraw money before reaching a certain age. However, the Roth IRA is unique in that you can withdraw some of your money without punishment, and almost all of it in other situations without reaching the retirement age.
Principal & Earnings
To understand the withdrawing rules related to a Roth IRA, we need to understand the difference between principal and earnings. Let’s say that you funded your Roth IRA with $5,500 in the beginning of the year. You’re also a savvy investor so your account grew. It’s the end of the year, and your Roth IRA is now worth $6,000.
The total value of your Roth IRA is comprised of two things, your principal and your earnings. Your principal is what you originally put into the account. In our little example, that amount is $5,500. Your earnings is the amount that your Roth IRA grew by. In our example, its $500. Just in case that’s a little fuzzy, look at the graphic below to have it explained in terms of Giraffes.
When can you withdraw principal?
Short answer: Anytime. Longer answer: Anytime you want as long as you can convert whatever is in your Roth IRA to cash. Typically, you can’t take securities (stocks, bonds, etc.) out of your Roth IRA directly. You need to first sell the securities to obtain cash. Then you can take the cash out.
When can you withdraw earnings?
Withdrawing earnings in a Roth IRA is a bit more nuanced than withdrawing principal. After you become 59.5 years old, you are free to withdraw the earnings without any penalty, assuming you have had the account for more than 5 years. For example, if you start a Roth at age 55, you will need to wait until you are 60 to withdraw earnings without penalty.
You can also withdraw $10,000 worth of earnings if you are a first time homebuyer and use the $10K you withdrew to buy your house. However, this is generally not a good idea (unless you’ve found a killer deal and have no other funding options) because you are stifling the exponential tax-free growth of your Roth.
Roth IRA’s grow tax free. This means that whenever you get a dividend (cash payment) or realize a capital gain (i.e. sell something for higher than you bought) you don’t pay the government any tax on it. This allows your account to compound and grow exponentially faster than usual. In addition, (assuming you followed all of the rules), whenever you take money out of a Roth IRA, you don’t pay the government tax on it. The catch? There aren’t any, except for the fact that you have already paid taxes on the money you used to fund the account.
In the case that you mess up and accidentally withdraw interest, you will end up paying income taxes on the interest along with an extra 10% penalty. If you do this by accident, you can take advantage of the roll-over rule, which prevents you from facing penalties as long as you refund your Roth within 60 days. However, you can only do this once per year so be careful!
Alright, let’s summarize
Whew, those were a lot of rules! Let’s quickly summarize the important contribution and withdrawal rules before moving forward.
Quick Contribution Guide (2017)
Quick withdrawal guide (2017)
Should I open a Roth?
Whether or not you should open a Roth IRA depends on your financial situation, so telling all of you to go and immediately open a Roth would be disingenuous. So, to better help you decide whether or not opening a Roth IRA is a good decision for you personally, I’m going to describe the qualities of a person who would get the maximum benefit from a Roth IRA.
- Can save $5,500 (or whatever amount you will contribute) without incurring financial hardship (i.e. not being able to afford food, housing, or paying off debts)
- Expects to increase the amount of money earned in the future
- Values the ability to withdraw principal without penalty prior to retirement
- And, most importantly, is willing to learn about investing
If the 4 bullet points above resonate with you, I would highly recommend opening a Roth IRA.
What can I invest in?
DISCLAIMER: I have not fully investigated all of the following options. I’m only briefly discussing what I know of the following options, and unlike I-bonds, these options carry risk (i.e. you can get screwed).
Certificates of Deposit
This is probably the most boring Roth IRA investment you can make. Basically, you deposit some cash into a Roth IRA. From the Roth IRA, you deposit the cash into a bank and promise to leave it there for a while. The bank then pays you a slightly higher interest rate (than you would get from a normal savings account).
- CDs (certificates of deposits) don’t require much research (although you may want to compare rates between different banks)
- The return (how much cash you make) from a CD is usually low
- CDs are extremely safe (it is cash in a bank after all)
- CDs are very liquid in the sense that they can be converted to cash quickly (CDs are made of cash), however, you may have to pay a penalty of some sort if you try to withdraw the CD before its term expires.
Stocks using a Self-Directed Brokerage account
When people talk about investing, stocks are probably the first thing that comes to mind. A self-directed brokerage account is an account that you can use to purchase just about any traded security, (stocks, bonds, mutual funds, ETFs, etc.). This is probably the best type of Roth IRA to open because it gives you the most investment choices.
- Investing in stocks typically requires a lot of research (unless you want to gamble and randomly pick some to speculate in)
- The potential return on the stock market is very high.
- The stock market typically isn’t very safe (although this varies depending on the investments you choose)
- The stock market is usually liquid (however this varies depending on the investments you choose)
Lending Club / Prosper (P2P lending)
Peer to peer lending is an interesting investment option for a Roth IRA that has only recently come about. Basically, you turn into a bank and loan strangers your money. Lending Club and Prosper set up an online environment where you can loan small amounts of money ($25) to many different borrowers. After some time, the borrowers pay you back plus interest. If you would like to learn more, read David’s article on P2P lending (just note that Lending Club has implemented automatic investing).
- Peer to peer lending does not require as much research since you are only focusing on consumer debt. However, you will still want to read up on the different types of loan applicants so you know the risk profile of your investment.
- The returns on peer to peer lending can be really high. I’ve seen people report earning up to 10% a year on their investment. Lending Club also claims that the average investor earns 5% a year (although this is probably closer to 4% after fees).
- Consumer debt isn’t very safe. If the person you loan money to decides they never want to pay you back, you are out of luck. In addition, the borrowers can declare bankruptcy to rid themselves of their debt.
- Lending Club debt investments are not very liquid. In order to cash out, you would have to sell your loan notes on a secondary market, which would require effort on your part.
Let’s quickly summarize
How can I get started?
First off, if you don’t have an emergency / opportunity fund, I highly recommend starting one before fueling a Roth IRA.
In order to open a Roth IRA, you need a financial custodian (a financial custodian is like a parent for your Roth IRA account, they take care of it and assist if you have any problems). I personally use schwab as my financial custodian. They don’t seem to have any weird fees and I think their service is decent. However, I have not tried out other custodians so I have no perspective as to whether or not schwab is a good custodian.
Quick Guide on opening a Roth IRA account
- Pick a financial custodian. If you are having difficulty choosing a custodian, check out Jeff’s reviews over at goodfinancialcents.com
- Complete a ton of online paperwork. Typically you will be asked to provide all of your personal information including your bank account number, routing number, and social security number.
- The next step is to link your bank account to the financial custodian. They will do this by making two deposits into your bank account (usually under a dollar). Then, you tell them the exact amount that they deposited into your bank account, thus verifying that you are the owner of that account.
- After your bank is linked, you can transfer funds from your bank account to your custodian at any time by authorizing a transfer. This process usually takes 3 business days to complete (which is pretty ridiculous…once I find a custodian + bank that can transfer funds in a timely manner, I’m switching in a heartbeat).
- As soon as money is deposited with your financial custodian, you are free to invest!
In the end, the Roth IRA is just a game with some really weird rules. Should you choose to play by the rules, (and or push them to their edge) you will be rewarded significantly through tax-free growth. Although the Roth IRA does not make sense for every single individual, it will heavily benefit those who expect to increase their earning potential further down their careers and are willing to learn how to invest. Simply putting away a few thousand tax-advantaged dollars today does a lot towards creating a future where money isn’t something you need to worry about. The Roth IRA is a powerful tool, and its up to you to use it.