Roth IRA
Last week, I spoke to a few people who mentioned that they didn't understand the benefits of having a Roth IRA investment account or didn't open an account because they didn't think they qualified. I hope to clarify why everyone who is producing income can be eligible and why everyone should have a Roth IRA account.
For 2021, if you are single and make less than 125K, you can invest a max of 6K a year into a Roth IRA. If you are married and filing a joint tax return with your spouse and make less than 198K, you can contribute 6K each. If you are over 50 years old, you can contribute up to 7K a year in both scenarios. If you make more than this, you do what is called a backdoor Roth IRA instead in which for a day you place the money in a Traditional IRA under a money market account and the next day transfer this money into your Roth IRA account. If you need help with this part, any large investment management company such as Vanguard can help.
When you put money in a Roth IRA you are using after-tax money. This money will invest in the stock market, and how you invest this money will be up to you. If you wish, you can remove your contributions to the account tax-free and without penalty at any point in time. The only difference in the backdoor Roth IRA scenario is you can not pull the money you converted from the Traditional IRA to the Roth IRA for five years. If you wish to withdraw earnings from a Roth IRA, it can also be tax-free if you have had the account for greater than 5 years and have had a qualifying event. Qualifying events include; age over 59.5, having a permanent disability, being taken by a beneficiary of your estate, or buying, building, or rebuilding your first home to a max of 10K. If you remove earnings without a qualifying event, you will pay income tax on this money and pay a 10% penalty.
The benefits of a Roth IRA are significant. The contributions invested can be removed at any time tax-free with a minor exception, as mentioned earlier, vs. a 401K, which you can not pull from until 59.5. The withdrawal on earnings can be tax-free if you have had the account for longer than five years and have had a qualifying event. If you have had the Roth IRA for 20 to 30 years, the tax-free earnings at a historical average return of 10 percent in the stock market are substantial. When you remove money from your Roth IRA, it doesn't affect your taxable income as it has already been taxed and will not move you into a higher tax bracket. This benefit is significant in retirement when you live on the income you have earned and are no longer working. Having a Roth IRA account is also a hedge against future tax rate hikes, as it has already been taxed and therefore can not be taxed at a higher rate later as opposed to 401k money, which will be taxed when you remove it.
I understand that each individual's situation regarding extra income, student debt, and risk tolerance is different. I cannot definitively say when is the best time to open a Roth IRA account, but I can offer guidance. As with most investment accounts that invest in the stock market, the sooner you invest, the better as you allow the power of compounding interest to work for you. In addition, I would also say that those in a lower tax bracket who expect to make significantly more in their mid-careers would also benefit considerably from opening a Roth IRA account ASAP. Suppose you have already maxed out your 401K, taken advantage of your employer's match and other pretax investment accounts, and are looking for another investment vehicle. I think a Roth IRA is the next step.
A tip I find helpful when funding my Roth IRA is to do this at the beginning of every year because it gives it the maximum time to grow.
