All About Roth (IRA)

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Cartier Tank Francaise Watch – timeless!

I’m the type of gal who likes to only own a few accessories.  Not a whole drawer full or jewelry boxes full, just one or two really, that can be paired with any outfit, dressed up or dressed down.  To that end, one of my favorite accessories is my Cartier Tank Française Watch.  It’s a multitasker!  Not only is it functional as a watch, it also just looks really pretty. ?  It goes with any outfit in my opinion, from dresses to work clothes to jeans and a top.  Kind of a weird analogy, but I see the Roth IRA like I see the Cartier watch.  It’s a multifunctional savings account that can be used for many a financial purposes.  Many of you have probably heard of the Roth IRA, but you may or may not really know what it is and how useful it is as part of your overall investment strategy.  If you can afford to, you should ideally be maxing out your 401k or other equivalent retirement plan and a Roth IRA every year.

What is a Roth IRA?  It is a wonderful little account that can be a source of tax-free money for you if cultivated properly.  For a majority of people, the Roth IRA may be the only good way to generate a tax-free stream of income in retirement.  You invest after-tax money into a Roth IRA, which grows tax-free and at a later time can be withdrawn tax-free as long as (1) the account has been open for at least 5 years and (2) you’re 59½ years old (with some exceptions as we’ll see below).   Though it is designed to be a retirement savings account (hence the name IRA = Individual Retirement Account) it actually can be used for so much more than just for retirement.

Roth IRA vs. Traditional IRA.  A unique feature of the Roth IRA compared to a traditional IRA or even a 401k is that you can withdraw your contributions (the money you put into the Roth and already paid taxes on) at anytime without penalty or taxes, but not the earnings portion.  If you do withdraw the earnings portion before the account’s been open at least 5 years and before age 59½ you will have to pay a 10% penalty and taxes on the earnings portions you withdraw.  The other unique aspect of the Roth is that there is no required minimum distribution (RMD) for the Roth IRA during the owner’s lifetime, unlike all other retirement accounts (i.e. traditional IRA, 401k, SEP-IRA, etc).  RMD is the minimum amount you must withdraw from your accounts each year after you reach age 70½ otherwise you’ll have to pay a huge penalty.

Income Limits.  Unfortunately for higher income earners the Roth IRA has income limits set by the IRS every year.  For 2015, the limit was a modified adjusted gross income (MAGI) of $116,000 – $131,000 for a single person and $183,000 – $193,000 for a married couple as summarized in the table below (taken from the IRS website).  This effectively means that singles earning $131,000+ and marrieds earning $193,000+ are ineligible to contribute to a Roth IRA directly.  There is a way to contribute indirectly via a Roth conversion (aka Backdoor Roth IRA) which we will discuss in the next post.  So stay tuned!

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Roth IRA Contribution limits for 2015 from IRS website

Roth IRA for first time home buyers:  One of the exceptions to early withdrawal from a Roth IRA is if you use the money for the first time purchase of a home.  You can withdraw up to $10,000 from your Roth IRA as long as it’s been open at least 5 years.  That’s a pretty paltry amount for a home purchase, especially if you live in California, but remember that you can touch the principle portion of the Roth IRA at any time.  So let’s say you’ve contributed the maximum amount of $5500 for 5 years ($5500 x 5 = $27,500), and the total amount in your Roth currently is $40,000 ($12,500 is your investment returns or earnings portion).  If you wanted to use the money towards a down payment for a first time home purchase, you can withdraw $27,500 at anytime without penalty or taxes (your contributions) and $10,000 of the earnings portion for a total of $37,500.

Roth IRA for college savings:: I wrote about this a bit in my What’s The Best Way To Save For College post, but no harm in recapping.  Another exception to being able to withdraw the earnings portion of a Roth IRA prior to age 59½ is if use the funds for qualified higher education expenses, i.e. college expenses.  You won’t have to pay the 10% penalty on the earnings but you will have to pay taxes.  This is different from the first time home buyer situation where you can withdraw the earnings portion up to $10,000 without having to pay the 10% penalty OR taxes.  In other words no penalty or taxes for first time home buyers up to $10,000 but for higher educational expenses, only no penalty.  That’s why its probably best to only touch the principle portion of the Roth IRA if using for college expenses.

Roth IRA for estate planning and as a legacy:  As mentioned above Roth IRA’s do not have a RMD, therefore the account can be kept untouched throughout your life allowing the money inside to compound even longer and upon your passing it can be left for your heirs as a stretch IRA or to your estate where it can pay for any estate taxes.  A stretch IRA can be a strategy to pass down a significant amount of wealth across generations without incurring any taxes because again the Roth IRA doesn’t have a RMD and you could’ve socked away a lot of money over your lifetime along with the awesome power of compound interest and tax-free growth and then pass it onto to your child or even grandchild.  They would have to start taking RMD’s from it 5 years after you pass, but the RMD’s are inversely proportional to the age of the beneficiary, where the younger the recipient, the lower the RMD amount allowing the Roth IRA to grow for even a longer period.  Crazy coil right?

Roth IRA as emergency savings:  Not recommended to use as an emergency savings account because part of the power of a Roth IRA is allowing the contributions to grow uninterrupted tax-free over as long a period of time as possible, but isn’t it good to know that IF you have a major financial emergency, you can always withdraw the contributions portion of the Roth at anytime?  Additionally, you can also make early withdrawals from your Roth IRA if you become totally and permanently disabled without paying the 10% penalty or taxes or if your medical expenses exceed 10% of your adjusted gross income without paying the 10% penalty (but you’ll have to pay taxes though similar to using it for college expenses).

Summary of the features of a Roth IRA:

  • You need to have earned income to contribute to a Roth IRA though you can open a spousal Roth IRA for your stay at home parent.
  • Contributions into a Roth are non-deductible (after-tax money), but grow tax-free inside the Roth.
  • Distributions or withdrawals are tax-free and penalty free as long as the account has been open for 5 years (5 year rule) and your age is 59½ or older (there are exceptions), otherwise 10% penalty and taxes on the earnings portion only.
  • There are contribution and income limits to a Roth IRA.  For 2016, max contribution is $5500 per working person and income limit is $131,000 for single tax filers and $193,000 for married filing jointly.
  • Contribution portion only in a Roth IRA can be withdrawn at anytime without penalty or taxes.
  • There are no required minimum distributions with a Roth during the owner’s lifetime.

So there you go, the multifunctional Roth for your financial wardrobe.  Now I bet you want to open one up right away and you should.  You can still open up a Roth IRA for 2015 by April 18, 2016 tax day and you can make contributions for 2016 too until tax day in 2017.  What did you think?  Anybody decide to open a Roth IRA because of this post?  Let me know!  Thanks for reading and come again.

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