I'm a big proponent of Roth IRAs. The tax advantages of these types of IRAs are too good to pass up for those who qualify. This is especially true to the younger crowd whose income will likely place them in a higher tax bracket by the time they retire.
In this post, you'll learn about Roth IRAs and the tax advantages of them. I'll share a few practical examples of how tax-free growth can save you hundreds of thousands of dollars by retirement.
What is a Roth IRA
A Roth IRA is a retirement savings account where you contribute after-tax dollars to then grow your money tax-free until you meet withdrawal requirements. When you withdraw money from your Roth IRA, you will not pay taxes on your earnings.
With a Roth IRA, you can invest in equities such as stocks, bonds, mutual funds, index funds, and more. In 2020, the Roth IRA contribution limit is $6,000 per year if you are under age 50 and $7,000 per year if you are age 50 or older.
The power of a Roth IRA is in the tax-free growth of your earnings. If you deposit $6,000 per year, every year, and earn a steady return-on-investment, you will be able to withdraw your money tax-free when you're age 59 1/2 or older.
Requirements to Get a Roth IRA
You can contribute to a Roth IRA if you don't exceed the income limits. If your taxable income and modified gross adjusted income meets the following requirements, you can contribute to a Roth IRA.
- Less than $194,000 if you are married filing jointly.
- Less than $132,000 if you are single, head of household, or married filing separately (if you did not live with your spouse at any time during the previous year).
- Less than $10,000 if you're married filing separately and you lived with your spouse at any time during the previous year.
How to Open a Roth IRA
You can open a Roth IRA account at a brokerage firm of your choice. An online broker generally makes sense if you want to pick your own investments.
When looking for a broker, you'll want that offers many tools, including calculators and retirement planning tools. You'll also want access to a wide array of mutual funds and index funds.
If you're not sure which investments to pick yourself, signing up for a firm with robo-advisors may make more sense. Robo-advisors will help you pick your portfolio and manage it for you, assessing a small advisory fee.
If you're looking for a brokerage to open a Roth IRA, I recommend the following:
When is the Roth IRA 2019 Contribution Deadline
In 2020, the tax filing date deadline was extended to July 15th. You can now contribute to your Roth IRA for 2019 up until July 15th, 2020.
Rules for Withdrawals
You can withdraw contributions penalty-free at any time, however if you withdraw earnings that don't meet specific requirements, you will have to pay taxes on your earnings as well as an additional 10% penalty tax.
In order to withdraw money penalty-free, called a “qualified distribution”, you must be at least 591/2 years old, and at least five years must have passed since you started contributing to your account.
There are exceptions to this. You can withdraw contributions and earnings for a qualifying first-time home purchase, for disability, for some college expenses, and certain other less common situations.
When you make a qualified distribution, you don't pay taxes on your earnings. That is, you take full advantage of tax-free growth along with a tax-free withdrawal.
Tax Advantages of a Roth IRA
The best part about a Roth IRA is the tax benefit. If you contribute $6,000 per year and let's say for example your money grows to $500k by the time you retire, you can withdraw that $200k as non-taxable income to you. In contrast, with a 401(k), you contribute pre-tax dollars but are taxed upon withdrawal.
This tax-free growth can propel your retirement nest egg amazingly. In fact, if you start contributing to a Roth IRA at 25, and contribute $6000 per year for 35 years, and assume a 9% net annual return, you would have just under $1.3 million when you turned 60, which you could withdraw all or in part, without owing a penny in taxes.
An Example of How Tax Savings Work in a Roth IRA
An argument to use a Roth IRA, or any retirement account for that matter, is how your money is protected from taxation year-to-year. Tax-free growth is hard to argue with.
The example I use below shows what happens when you invest $5000 per year into a Roth IRA with a 9% annual growth versus investing the same $5000 into a taxable account where you are taxed every year – same 9% growth. Let's assume you were taxed at 24% each year.
First, a 30 year look at investing $5000 per year at 9% return on investment, no tax.
After 30 years, we have just over $740k. Not bad! But what happens if we had to pay a 24% annual tax on the same investment? Here's what that would look like.
As you can see, over 30 years, you end up losing about a third of your nest egg if you paid taxes each year. By safely locking your money into a tax-advantaged Roth IRA, you will end up with over $250,000 more than if you incurred taxes.
Wrapping It Up
It's really quite amazing how tax-free growth can save you hundreds of thousands of dollars. That said, diversifying your portfolio across multiple types of investments will mitigate your risk the most.
There's also the possibility that you don't qualify for a Roth IRA or that you have more than $6000 to invest each year. In these cases, using other avenues of investing may work better.