One of Independent Financial Planning’s favorite universal investment concepts is to take advantage of tax-deferred and tax-free vehicles for retirement. I have a chart that I often show in presentations that shows how much better a Roth Individual Retirement Account (IRA) is compared to a non-retirement investment account. It has more than its fair share of assumptions but the bottom line is that saving in a Roth IRA is extremely beneficial toward retirement.
The real benefit to a Roth IRA is that once you pay taxes on your contributions, all the earnings in that account will be tax-free and when you take money out of the Roth IRA. Not having to pay taxes is an enormous benefit to an investor, especially one who plans to have to pay taxes once he or she is in retirement. There is another benefit in regard to flexibility that I’ll mention later. Before I get to that, let me mentioned the rules regarding Roth IRAs.
The first thing to know is that an IRA is just a vehicle and not the investment itself. The investments can be stocks, bonds, mutual funds or pretty much anything else that can be found in a non-retirement investment account. There are a few rules in regard to assets that cannot be in a Roth IRA but in general an investor has many options available.
Secondly, there are limits that pertain to whether and how much you can contribute each year. There is an income minimum and maximum and an age adjustment. For 2015 a single investor who has earned income under $113,000 and is under 50 years old can contribute $5,500 and over 50, $6,500. A married investor filing jointly can contribute if earned income us under $183,000 at the same maximum amounts. If you don’t have earned income you can’t contribute unless your spouse works and has earned income. For income amounts above $113,000 and $189,000 there are phase outs or a declining maximum amount you can contribute to the account. I often get asked why there are these maximums and confusing rules. My response is that the government wants to encourage people to save for their retirement without benefitting people who make so much.
Third, you will be penalized if you invest in a Roth IRA account and take out any of the earnings prior to the year you turn 59½. Notice I wrote earning and not contributions. I often tell prospective clients of Independent Financial Planning that the Roth IRA is preferable to the traditional IRA because of the ability to take out your contributions tax-free if you need to. It’s another option in case you need the money before you’re 60.
This isn’t an exhaustive list of the details regarding Roth IRAs but I’d like to mention one more feature. If your income is above the maximum limit you can still get money into a Roth IRA, just not directly. You can always make a non-deductible contribution to a traditional IRA and then convert it to a Roth IRA. There are not any additional taxes for doing it that way and it appears to me to be a loophole that allows high earners to get money into a Roth IRA.
There are many ways to save for retirement and at Independent Financial Planning I’m actively looking for ways that clients can save money in the most effective manner to help achieve their goals. Roth IRAs happen to be one of the best ways to save for retirement for investors of all ages. In later posts I’ll mention some of the times in life that make for great opportunities to get money into Roth IRAs. In the meantime keep charting the course.
This is a good Khan Academy video on understanding Roth IRAs and contains a numbers comparison to Traditional IRAs.
