Planning for Retirement: All About Roth IRAs

Retirement is one of the most exciting stages of life. We all look forward to it and dream about what it looks like the closer it gets. Will we travel to exotic places? Have lots of grandkids to spoil? Find new hobbies? Sell everything we own and drive the country in an RV? (Kaimey will never go for that one.)

It is fun to dream about retirement, but it can be intimidating as well because there are questions to be addressed, other than the fun ones.

When do I want to retire? How much lower will my expenses be at that point? Or will they be higher?! What investment return will my portfolio earn? Will inflation eat that all away? What are future tax rates going to be?

I hate unknowns, but identifying them and coming up with realistic assumptions are necessary in planning. Considering the worries above, there is an easy way to reduce the impact of at least one of those questions: What are future tax rates going to be…

Last month we wrote about our favorite investment account, the Health Savings Account. Today I want to talk to you about my second favorite account: the Roth IRA.

You may be familiar with Roth IRAs, but many people don’t know much about them since they haven’t been around very long. These accounts were first allowed by law when Senator William Roth from Delaware included them in his Taxpayer Relief Act of 1997.

Comparing Roth IRAs with Traditional IRAs

With a Traditional IRA:

-You get a tax deduction in the year you contribute money to the account.

-You get tax-deferred growth as long as you leave it in there.

-You pay taxes on everything you pull out of the account in the future.

With a Roth IRA you do not get any deduction in the year you put money in, but you still get tax-deferred growth as long as you leave it in there. And when you take the money out, the contributions and earnings both come out tax free!

Why would the government ever let us have a tax-free IRA? Well, in their eyes they get to collect their taxes upfront instead of waiting like they have to do with Traditional IRAs.

Let me summarize some of my favorite and least favorite aspects of Roth IRAs.

What I love about Roth IRAs

• The earnings are tax free, forever. You just have to wait until the account has been open at least 5 years and you are 59½ years old or older.
• You don’t have to worry about what tax rates might be in the future and how this will erode your Roth IRA account.
• You can take your contributions (not the earnings) back out without any tax penalty if you need it in an emergency.
• There are special rules that allow you to take some money out of the account to purchase your first home, pay for college, etc.
• You do not have to start taking Required Minimum Distributions at age 70½ like you do with Traditional IRAs.
• You can contribute to a Roth IRA at any age as long as you have earned income. (With a Traditional IRA you cannot make future contributions after age 70½.)
• You can contribute to a Roth IRA for your stay-at-home spouse even if they do not have earned income.
• This is a great account to leave as an inheritance to future generations. They do not pay any income tax when they take the money out either.

What’s Not to Love About Roth IRAs

• You can only contribute $6,000 maximum per year ($7,000 if you are age 50 or older).
• If you are high income (married filing jointly, making over $200,000 or so), you may not be able to contribute to a Roth IRA. There is a way around this, known as a Backdoor Roth Contribution, but I’ll have to write about that in a future blog post.
• You have to have “earned income” to contribute to a Roth IRA. Salaries and wages count, but investment earnings do not. If your earned income is less than $6,000, you can only contribute that amount.
• If your tax rate in retirement is less than it is now (which is the case for most of us), you may actually save more on your lifetime tax bill by using a Traditional IRA.

One of the absolute best ways to use Roth IRAs is as the first retirement savings account for your working child. This strategy is often referred to as the Mommy/Daddy Match. If your child (of any age) earns legitimate wages from a job, they can contribute to a Roth IRA. For example, say your 15-year-old child earns $3,000 over the summer working as a lifeguard. Offering to match any money they put into a Roth IRA is a great way to teach them about money, saving, and investing. If they put in $1,000, you also contribute $1,000. Just make sure the total contribution for the year is not more than their earned income.

If that 15-year-old put $3,000 into a Roth IRA and invested it earning a 7% annual rate of return, it would be worth over $88,000 when they are 65. Tax free! And that’s if they only do one contribution and no more. Imagine if you encourage them to start doing this every year…

There is much more to learn about Roth IRAs that I couldn’t cover in this post. If you want to learn more or find out if a Roth IRA is right for you, reach out to me! I’d love to help you.