"Nothing is certain except death and taxes." - Benjamin Franklin
...Unless you are investing in a Roth IRA - then taxes are not certain.
- A Roth IRA is an individual retirement account
- After tax money -> grows tax free -> qualified withdrawals tax free
- Deposit limits are the lesser of $7,000 and your earned income
Roth IRA Basics
The Roth IRA was first available in 1998. It is a type of individual retirement account meaning anyone can open one regardless of where or if you are employed. It is widely regarded as one of the best retirement savings accounts mainly thanks to its tax free qualified withdraws.
Roth IRA Contributions
The Roth IRA should be one of the first accounts you open and fund after contributing first to your employer 401k to get the match. Each year you can contribute $7,000 and individuals over 50 years old can contribute an extra $1,000 for a total of $8,000. However, you cannot contribute more than you make. For example, if you make $5,000 one year, you can only deposit $5,000 or less into a Roth. If you make $50,000, you can only deposit $7,000. Unlike a 401k or a traditional IRA, there are no deductions on these contributions.
Roth IRA Growth
Each year any capital gains, interest, or dividends you might incur are not taxed. This means you can sell assets and rebalance without worrying about large gains being taxed. This makes the Roth a great option for securities that will grow a lot or pay lots of income. For this reason tax free bonds or tax managed funds should be avoided inside a Roth.
Qualified Roth IRA Withdrawals
When you are ready to take money out of your Roth, you do not pay any taxes on qualified withdrawals. Below are the rules for qualified withdrawals.
Age
You can withdraw money tax free starting at age 59 and a half (59.5).
Account Age
Your account must be open for at least 5 years before you withdraw money from your Roth. This means if you open a Roth at 57 years old, you can't withdraw money until 62. Even though at age 59.5 you would be above the age to take money out, because your account has not been open for 5 years you have to wait. This is why it's a good idea to open a Roth as soon as possible even if you have no plans of funding it now.
Contributions
At any time, you can always withdraw what you put in. If you put in $5,000 a year for 3 years, you can withdraw that $15,000 whenever you want without needing to reach age 59.5.
First Time Home Purchase
You are allowed to withdraw $10,000 for a home purchase if:
- You are a first time home buyer
- You have to withdraw the funds within 120 days after closing
There are some other less common qualified withdraw exceptions that can be found on the IRS website.
Any non qualified withdrawals will face a penalty of 10%.
Conclusion
The Roth IRA is an amazing retirement saving account. Most financial advisors would recommend this account as one of the first accounts you fund for retirement. Be sure to open this account early and fund it often to reap the most benefits at retirement.
