If you are already participating in your company 401k and are able to save more, then you might be wondering what’s the next steps.
Should you try and save enough where you can max out your 401k? plan for some vacations? Or do something else altogether?
If you are already taking advantage of the free money your company match has to offer, then the best way to supplement your retirement and supercharge retirement savings is to get a Roth IRA.
Why? Well, I’m going to go right out and say it.
Because the Roth IRA is one of the best investment vehicles available to folks for dynamic wealth building.
Not just because of its tax savings ability, but also because of its flexibility.
Although, I am a firm believer that emergency funds should remain completely liquid, being able to function as an extreme emergency saving that can be tapped without penalty or taxes is super attractive because it helps you complete several goals at the same time.
It has all the makings of a small but super tool for your money-making machine. So I’m going to go fanboy for a little bit and give you some details on what’s great about it and how I plan to maximize the benefits.
First the housekeeping. What is a Roth IRA?
It is an individual (meaning per person, not shared with your spouse etc) retirement account. It has special tax savings because it is a retirement vehicle.
Here is how it works!
- You put in after-tax dollars (after you receive your paycheck money) to the Roth Individual Retirement Account (IRA).
- Earnings grow tax-free and withdrawals are also tax-free at 59 1/2! Hence the saying ‘you pay tax on the seeds, not the crop.’
- You can withdraw the money you put in at any time, for any reason, tax-free
- The most you can contribute depends on your income level. Currently, as of 2016, the maximum annual contribution is $5500 for persons under 50. Persons over 50 are allowed a $1000 catch-up amount with a maximum contribution of $6500. Phase-out starts at $117,000 for single, 184,000 married; and unfortunately, you can’t contribute if your adjusted gross income is $132,000 for single filers and $194,000 married
- Backdoor entry available if ineligible. If your income disqualifies you from a Roth IRA, you can make a contribution to a traditional IRA or 401k, and then roll it into a Roth IRA, however, you will need to pay the taxes on the rollover at your current tax rate. If you take this route, try to plan a rollover when you will be in a lower bracket. For instance, if you are going back to grad school, starting a new business, planned unemployment etc. So when the life change is underway you can make the rollover. Remember that the amount rolled over will count as income so you want to make sure the rollover doesn’t bump you into a new tax bracket
- Unlike with a traditional IRA, you do not get a tax deduction – Since you get the tax break on the distribution end, there is no tax break for contributions … boo!
Now here is what makes it awesome and why I max out on my Roth IRA once I hit my company matches minimum in my 401k!
It can be my emergency, emergency fund.
When you put funds into a traditional 401k that money is before tax dollars and is happy earning tax-deferred growth. That means you pay taxes LATER when you take the money out so don’t be fooled, Uncle Sam will get his cut. And if you need the money before you are retired, you’ll get slapped with a penalty too.
Not so with the Roth IRA. You can withdraw the money you put in any time – any day – without penalty and without paying ANY taxes. So if you got aggressive with savings and later found yourself in a situation where you needed some quick funds, you could pull the money out and do whatever you want – no restrictions, questions or taxes.
I’m a ‘no contract’ ‘multiple exit strategy’ loving kind of girl so I for one, love this about Roth IRAs. Because your money isn’t held hostage where ransom must be paid for retrieval!
Now I will say this, it isn’t recommended to use your Roth IRA as an emergency fund since we are trying to work on building wealth. However, if something catastrophic or amazing were to happen (like buying a house or getting married), you could quickly liquidate your contributed amount and use your Roth IRA as an exit strategy.
Tax-free Compound interest rocks!
Albert Einstein is rumored to have said that “compound interest is the most powerful force on earth”. I don’t know if that’s true, but if it is, then that’s real talk, Albert!
With your money in a Roth IRA, you are able to participate in the market which on average gives better returns than if the money was sitting in the bank. I’ve said it before, the power of compound interest over several years is mind-blowing. And the JP Morgan Chase Retirement Guide shows just how powerful compound interest is. This kind of wealth building possibility deserves another look. Check out these 3 friends
This kind of wealth building possibility deserves a good look. Check out these 3 friends
Chris invests $5000 each year from age 25 to 65. With a 7% return, by the time he turns 65, he’ll have over $1million! That’s a little less than 500% return.
Susan invests $5000 each year from age 25 to age 35. After that, she stops investing but leaves the money invested. With the same modest return, by the time she turns 65, she would have saved over $560,000. For just $50,000 investment over the course of 10 years, getting half a million is pretty badass.
Bill, on the other hand, waits a few more years – paying off debt – before deciding to get serious about saving. He invests the same $5000 per year from age 35 to 65 (over 30 years) with the same return. Overall, Bill invests 3 times the amount of money Susan invests and is able to save a little over $500,000 when he reaches 65.
The moral of the story? If you want to save less and get more money, then start early and save often. And, once again, you can’t beat the ‘magic’ of compound interest!
If something catastrophic, or incredibly awesome happens, I can withdraw earnings without taxes and penalties before retirement (under certain conditions)
It might sound the same as number one but imagine you want to plant an apple tree. You paid the taxes on the apple seeds when you bought them and you planted the seeds. being able to withdraw your contributions anytime without penalty or tax means if you change your mind and no longer wants to have apple trees then you can dig them up and get your money back no problem. However, if you plant the seeds and it grows into a tree, then any apples are free to eat without paying taxes (if you are yet 59 1/2, if not then you have to pay a 10% penalty).
In order to take advantage of withdrawing your earnings without penalty, you must be 59 ½ years old or older and have had the account for at least 5 years. But here are a few scenarios where if you meet the criteria then you are able to avoid paying taxes on your earnings:
The distribution is due to1:
- The IRA owner being totally and permanently disabled per IRS Code Section 72(m)(7).“You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration”
- Are used to pay for un-reimbursed medical expenses that exceed 10% of adjusted gross income (AGI)
- Are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks
- Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members – you, your spouse, or the children or grandchildren of you or your spouse.
- Are used to pay back taxes because of an Internal Revenue Service levy placed against the IRA.
- You use the distribution up to $10,000 to buy, build, or rebuild a first home.
So, if the crap hits the fan and you are in a real financial bind, like a massive medical bill, become disabled or need a deposit for my first home, then again, the Roth IRA can offer an excellent exit strategy. Even with the 10% penalty you still get a deal because if you had to pay taxes it would likely be more than 10% anyway.
This is great news for us, who purchase income properties and wonderful news If my son at some point decides to purchase a rental property with his Roth IRA, then he’ll get even added benefits.
4. Contribution deadlines
Found out about this awesome deal too late in the year? Not to worry. You have until the next year tax due date to contribute so I have lots of time to save up
You have until the until tax date of the following year to contribute to your Roth. So if it’s 2017 but you have a bonus coming in 2018 for your performance review, then you are able to use that bonus (extra cash) to invest in your 2017 Roth IRA contribution
5. Minimized tax bite in retirement
Raise your hand if you think that tax rates are going to decrease in the future. I don’t think so either. That’s one of the reasons the Roth IRA is a great tool.
Contributions are made with after-tax money so taxes are paid upfront. I know many folks are apprehensive about this, I still wholeheartedly jump in paying the taxes upfront. Why?
- Because I prefer to pay taxes on the seed (my small contribution) rather than the harvest (which is my large earnings).
- I expect that my tax bracket won’t go down very much in retirement because I’ll lose 2 of best deductions – having my kids as dependents and the interest from my mortgage payments so my AGI might still be a little high
- I fully expect taxes to increase in the future – obviously, it won’t get to 100% or something ridiculous, but I doubt it’ll stay the same for the next 30 + years
- And I want to spend my retirement years traveling, state hoping to see my grandkids (when I have them) and take them to all the fun Disney and Nickolodean places they want to see, volunteer etc. Any all those things cost money so my expenses might be the same as they are today, even after the kids are gone.
So in the example above, if you had invested like Chris, your contributions and earnings (all that $800,000+ ) is TAX-FREE! Imagine what the tax bill would be on that chunk of money if it was in another vehicle!
Where do you start?
Most people who understand Roth IRA really really want one.
I had already had a traditional IRA before I discovered the details about the Roth IRA, and I quickly opened an account with a robo-advisor, or any of the investment firms – Fidelity, Vangard, E-trade etc. – to get one started. And just like that, I had another investment vehicle that I could use in a variety of ways, diversify my investment portfolio and an avenue for building wealth.
It’s not perfect, but the advantages are undeniable.
Now that you know some of the secret awesomeness of the Roth IRA
What are you gonna do?