Highway to Retirement. Do not miss this overpowered tax cheat code! Roth IRA
February 14th, 2021 by D.C. Poc
If you are only going to read one of the articles here at The Wealthy Idiots (ha, not possible!), this is the one you must read! You’ve probably heard people mention a Roth IRA and that’s because it’s the gold standard of retirement tools. The Roth IRA is the whole shebang. It is easy to open, simple to operate, diverse, and has super low fees (which we’ll talk about more in future articles). Oh yeah, and depending on how you structure your financial planning, the Roth IRA could account for a “bucket” of income in retirement… a bucket of TAX FREE INCOME! Let’s jump into the specifics!
What is it?
The Roth IRA is an after-tax retirement account available at nearly every brokerage in the U.S. After-tax means you have already paid taxes on the money you invest. Growth is also tax free. Then, years later at retirement (specifically 59.5 years of age per current IRS rules), you withdraw the money tax-free. This is precisely why the Roth IRA is so valuable! Note that you can also withdraw your contributions tax and penalty free at any time, although you shouldn’t unless faced with an emergency.
The 2021 IRS contribution limit is $6k per person, but there is a stipulation that you must have earned income equalling or exceeding your contribution amount. If you file married-joint, the income of your spouse will suffice for meeting this requirement. This means that each of you can contribute $6k per year, even if one of you doesn’t work. For those age 50 or older, there is a $1k per year catch up contribution allowed, bringing the total to $7k for 2020.
Note that you have until April 15th of the following year to contribute to your Roth IRA. You read that right, if you open a Roth IRA right now you can contribute the max for 2020 as long as you do so prior to April 15th! Then, you have the rest of the year to work toward maximizing your 2021 contribution and getting that hot start to retirement.
Where Do I Sign Up?
Popular choices include Vanguard, Fidelity, and Charles Schwab. All of these brokerages will have an array of fund choices, many of which will carry very low expense ratios in the range of 0 to .10. Based on your individual preferences, you’ll be able to choose from stocks, bonds, mutual funds, and ETFs. If you want an even simpler approach, you can select a Target Date Fund (TDF) that has a risk level that corresponds with your estimated retirement date. Considering I am, or have been, a customer of each of these, I can tell you that they all have their own advantages and disadvantages, but overall, they are all excellent brokerages. Signing up is easy on all three of their websites. That’s not to say other brokerages aren’t good as well, but you’ll need to watch for things like excessive fees, annuity products, hidden life insurance products, and other predatory tactics. Remember, you can do this yourself, you don’t need the brokerage to “advise” you.
The Backdoor Roth IRA
In order to contribute directly to a Roth IRA, the IRS stipulates income limits. For single filers, the income phaseouts start at $125k and $198k, and completely phase out at $140k and $208k. If your income falls within these thresholds your contribution will be reduced or eliminated altogether. Don’t fret, this isn’t a deal breaker. There is a tried and true method to still contribute to a Roth IRA - and it’s on the up and up!
I would explain this method in detail, but the fine people over at Bogleheads.org have done it so well that I can’t do it justice. Check out their detailed article on how to navigate the Backdoor Roth IRA. In short, you contribute non-deductible contributions to a Traditional IRA, then convert those funds to a Roth IRA using the process outlined by Bogleheads.org. There are some considerations if you already have an existing IRA, so please be sure to read up. Once the process is complete, you’ll have Roth IRA funds with the same tax status as you would have gained by using the normal contribution process, voila!
So you’ve successfully signed up for a Roth IRA and now you’re probably wondering what funds your money should be invested in. Good, that’s a really good question and picking the right funds for you is key in sleeping well at night. There is honestly no set way of doing things. Personally, I am a huge proponent of index funds, i.e. funds that track market indices. By investing in these, you are guaranteeing yourself nearly the same return that the entire market gets. In other words, if you are invested in an S&P 500 index fund, and on Tuesday the S&P 500 gained 1.2%, you can assume you’ve gained around 1.2%. Using these funds, I employ the “set it and forget it” technique. I buy more of the fund everytime I make a contribution and then forget about it. When I reach 50 years old, I’ll start to re-examine my strategy due to my shorter investment horizon. My fund of choice in the Roth IRA is the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX). For you, it may be preferable to buy individual stocks. Maybe you want a little more conservative of an approach so you pick a TDF that coincides with your projected retirement year. Either way, the important thing here is ensuring that your money is actively invested. Give this money a chance to grow and it will reward you for years to come. The absolute worst thing you can do is build a large Roth IRA balance that sits in a money market fund for 20 years. You can thank me later while you’re touring Europe on a riverboat. (NOTE: This is still not financial advice).
Retirement Planning Considerations
The Roth IRA gives a different kind of flexibility in retirement - a tax free one. Because of this, you can create a plan that avoids unexpected tax events during your retirement years. Maybe you’ve been retired 5 years and decide you want a new car but are worried about how much money you have pulled from your 401(k)? Well, by using the Roth IRA for this you’ll avoid the dreaded federal and state (sometimes) income tax. Maybe you want to do a home renovation - same thing. Having this large sum of tax free money creates options, and in retirement, having options is often the difference between success and failure.
What to Expect Long Term
You knew this part was coming - let’s get down to the numbers. If you contribute $6k annually from age 22 until retirement at 57, you’ll have approximately $570k at a 5% return. That means if you and your spouse both do this, you’ll have over $1MM of tax-free funds available at retirement. Can you imagine being a tax-free millionaire? I can… that’s exactly why my wife and I hit our contribution limits each year. Keep in mind these numbers aren’t even accounting for the IRS increasing the contribution limit, which they review annually against inflation. They also didn’t account for catch up contributions after age 50. Now that you’ve got a clear understanding of the Roth IRA and are opening an account as we speak (I hope), let’s say you apply the logic that AJ Sheff laid out in his recent YouTube video and start upping your 401(k) contributions at work. You now have a pretty clear path to $2MM+ in your mid fifties. See, that wasn’t that hard! I think you get the point. Open a Roth IRA today!
D.C. joined the Marine Corps very young. When he left active duty, after 5 years of service, he quickly worked to get his MBA. He got his first "real" job at a modest salary and quickly worked his way up in promotions. Once he started making some money, he quickly realized he needed to learn how to save and secure his future. After nearly ten years of research, he wants to bring the knowledge and financial best practices to you so that you can also be a Wealthy Idiot.