by In the world of finance you hear terms like Roth IRA, Traditional IRA, 401K, SEP, Pension, etc. It can be confusing.
Today we are going to focus on one of these accounts, the Roth IRA.
The Roth IRA is considered a retirement account however it has a few unique aspects that we want you to look at. At the end of this we hope to accomplish a few things:
- Go over what a Roth IRA is
- Reveal a few of the benefits
- Provide you enough information so you can make a decision on if this account is right for you and your situation
What exactly is a Roth IRA?
The IRS defines a Roth IRA as “An IRA with exceptions” that they then list out. It’s a little confusing.
First IRA stands for Individual Retirement account. If you didn’t know that before now you know. If you knew that already, perfect! Let’s keep on cranking.
There are two very important differences between a Roth IRA and a Traditional IRA.
- Roth IRA contributions cannot be deducted from your income to reduce your taxable amount
- Distributions in retirement on Roth IRA’s are tax free! Read that again…tax free. The reason is you paid the taxes already.
Roth IRA Limits
So far this account sounds pretty attractive. Especially if you don’t need additional ways to reduce your taxes immediately and can hold out for the long haul.
There are few limits to the Roth IRA we want to make you aware of.
| Restriction | Single Filers | Married Filing Jointly |
|---|---|---|
| Modified Adjusted Gross Income | Less than $125K no restrictions | Less than $198K no restrictions |
(table above uses 2021 limits. Please consult your tax professional for confirmation)
So if you are below the limits above, please review annually as these values increase, then you can qualify for a Roth IRA. Nerdwallet has a really solid Roth IRA page that they update annually if you would like to take a look.
Contribution Limits
| Restriction | 49 or Younger | 50 or Older |
|---|---|---|
| ContributionLimit | $6k | $7k |
(table above uses 2021 limits. Please consult your tax professional for confirmation)
Annually you can contribute the amount in the chart above and allow your money to grow tax free.
An important item to keep in mind is that contributions annually are a use it or lose it. If you don’t contribute one year you can’t “Make it up” the following year. This is another area where disciplined contributions can allow you to use this benefit to your advantage.
You Can Withdraw Your Principal at Any Time…Without a Tax Penalty
Being able to “get your money” without consequences (read taxes) is another key benefit of the Roth IRA. Accounts such as 401K’s or Traditional IRA’s don’t allow you to take money out of them, unless you meet certain criteria (age, circumstances, etc). The Roth IRA allows you to get your principal at any time…since it is your principal. you haven’t received a tax advantage for the contribution.
Why does this matter?
Taxes, like fees, should be minimized so you get to keep more of your own money.
Let’s say that you were going to invest money for the next 3 years. At the end of the three years you were going to get your principal back to use for a larger purchase. It would look something like the following:
| Account | Contribution | Gain | Withdrawal | Will You Owe Taxes? |
|---|---|---|---|---|
| Roth IRA | $18k | $2k | $12k | No |
| Taxable Account | $18k | $2k | $12k | Yes |
In the above chart a few things:
- For the taxable account there may be ways to owe less taxes, such as selling stock at a loss, however the likelihood is you will owe some sort of taxes on the gain
- We used $6K as the annual contribution to each account type
Should You Open a Roth IRA?
In the end the decision is entirely up to you however if you are below the income limits we outlined at the start of this post we believe you should. You end up with great flexibility. You also might avoid taking the money out because it’s a “retirement” account.
Twins Rules for Financial Success
As with all of our content here we want to encourage you to follow three core rules :
- Have an Emergency Fund/Squirrel Funds
- Invest for the Long Term
- Invest Automatically & Consistently
