Now that we’ve talked about a Traditional IRA, I am going to turn to its far more attractive brother, the Roth IRA. I’ve written about the topic extensively, especially on the Investing for Beginners site, so this is just a quick rundown for me to reference when I bring up the topic as there is no need to reinvent the wheel. It’s meant as a sort of quick-reference guide for those of you who are considering it and want to have a general idea of how a Roth IRA works before consulting with your own qualified adviser.
The quick version: The Roth IRA is superior in almost every material respect to the Traditional IRA, and offers far greater long-term advantages for the disciplined, rational investor. Nothing in the history of the United States has come close to offering the scale and scope of potential advantages, if one is smart enough to take advantage of them.
What Is a Roth IRA?
Congress Passed the Taxpayer Relief Act of 1997, which was enacted on August 5th of that year. A provision in that law, named for Delaware Senator William Roth, create a new type of IRA, called the Roth IRA, that was meant to help middle class families build wealth and offer much better benefits than the Traditional IRA.
Like the Traditional IRA, the Roth IRA is an account. It is not an investment. Many financial institutions will allow you to open a Roth IRA. Depending on where you open the account, the service provider will give you the option to invest the money held in your Roth IRA into stocks, bonds, real estate, certificates of deposit, money market accounts, and a few other asset classes.
Each year, Congress limits the amount of money you can put into a Roth IRA, and only allows individuals with incomes below a certain threshold to take advantage of the program (though there is a way rich individual can get around this, which we will discuss later). Roth IRA owners do not receive a tax deduction when they put money into the account. Instead, they get a much better deal. They can withdrawal the principal anytime they want, without taxes or penalty, subject to a few restrictions. Any dividends, interest, rents, capital gains, or other profits generated within the Roth IRA are completely, totally tax-free. Furthermore, under current rules, when you go to retire and begin making withdrawals from the Roth IRA, you will not pay any taxes, at all, on any of the money.
Roth IRA Contribution Limits for 2013
Unlike the Traditional IRA, which is only open to those 70.5 years or younger, anyone with earned income (wages, self-employment income from farming, self-employment income from a business, or alimony) falling below the income levels we will discuss in a moment is eligible to contribute to a Roth IRA. The amount you can contribute in any given year depends upon your age and is either the lesser of your earned income or:
- $5,500 if you are 49 years old or younger
- $6,500 if you are 50 years old or older
The Roth IRA Income Limits for 2013
To make a contribution directly to a Roth IRA in any given year, you must below the income guidelines published by the IRS. It is important to recognize that these income limits are not your overall pay. They are based on something known as Modified Adjusted Gross Income (AGI). When you determine Roth IRA eligibility, you may get to deduct student loan interest expense, tuition and fees, domestic production activities credits, certain qualified bond interest income, certain employer-provided adoption benefits, etc.
For 2013, you must earn less than the following amounts to qualify to make a direct deposit to a Roth IRA.
- Single filers: $127,000
- Head of Household filers: $127,000
- Married Couples Filing Jointly: $188,000
- Qualifying Widow or Widower: $188,000
- Married Couples Filing Separately if You Lived Together at Any Point in the Year: $10,000
- Married Couples Filing Separately if You Did Not Live Together at Any Point in the Year: $127,000
Once you approach these limits, you may find your contribution limit is less than the full rate most people enjoy. For example, contribution allowances are reduced for people making the following income (to find the exact amount you are permitted to contribute to a Roth IRA, you would need to have your accountant complete the IRS worksheet):
- Single filers: $112,000 to $126,999
- Head of Household filers: $112,000 to $126,999
- Married Couples Filing Jointly: $178,000 to $187,999
- Qualifying Widow or Widower: $178,000 to $187,999
- Married Couples Filing Separately if You Lived Together at Any Point in the Year: $0 to $9,999
- Married Couples Filing Separately if You Did Not Live Together at Any Point in the Year: $112,000 to $126,999
Note: If you are self-employed, these limits could be achievable even if your income is much, much higher. You can take all sorts of write-offs ordinary employees can’t, such as deducting the amount you’ve contributed to a SEP-IRA, home office business deductions, health insurance premiums, etc. It’s entirely possible your household could be earning $300,000+ and, under the right circumstances, still have a Modified AGI figure that makes you eligible to contribute to a Roth IRA.
Making Withdrawals from Your Roth IRA
When you are ready to make a withdrawal from your Roth IRA, your tax situation depends on your age. The principal amount you contribute to a Roth IRA can be withdrawn from the account any time you want, without tax penalty, even while you are still young. You cannot, however, redeposit the money if you take it out of the confines of the Roth IRA’s protection. In practice, that means that if you’ve contributed $100,000 to a Roth IRA over the years, you could tap that entire $100,000 without any tax consequences, whereas with a Traditional IRA you would have been slammed with Federal, state, and local taxes, plus a penalty tax.
You will be subject to Federal, state, and local taxes plus a 10% penalty tax on any non-principal Roth IRA withdrawals (that is, money in the Roth IRA that did not come from your after-tax contributions, but instead from dividends, interest, rents, capital gains, and other profits) unless the withdrawal is considered “qualified”. To be qualified, the money being withdrawn must have exceeded a 5-year tax period, and meet one of the following conditions:
- Made on or after the day you turn 59.5 years old
- Made after you become disabled as defined by the IRS regulations
- Made to cover qualified expenses for first-time homeowners
- Made to your beneficiary or estate following your death
The Benefits of Using a Roth IRA for Your Retirement and Wealth Building
The accountant-types amongst you have already spotted some of the brilliant ways the Roth IRA can be employed to drop the effective tax rate of a family building wealth down to far below where it would otherwise be. To highlight the possibilities, let’s use a fictional scenario.
Imagine a married couple is 25 years old. They decide they want to contribute to Roth IRAs until they are 65 years old, then live off the dividends, interest, and rents. At average rates of return, they would likely end up with somewhere around $5,000,000 by the target date.
Arbitrage the Tax Code Through Asset Placement: An intelligent couple could invest the money in higher returning assets to effectively arbitrage the tax code through a method called asset placement or asset positioning. High quality corporate bonds yield more than high quality municipal bonds because the latter are tax-free. However, in a Roth IRA, there are no taxes. This means the bonds could be allocated to corporate issues, instead, picking up an extra 1% to 2% per year in income. (That is why you would never buy tax-free municipal bonds in a tax shelter such as an IRA.)
Use the Roth IRA as a Protected Engine to Generate Income then Make a Tax-Free Withdrawal of the Earnings: Remember the Roth IRA has no mandatory withdrawal requirements. That means you can keep the principal working within one for as long as you are alive. In this case, the couple could continue to hold as much money as they wanted within the Roth IRA, so the dividends, interest, rents, and capital gains are tax-free, then make withdrawals of those earnings whenever they needed money. If they took this approach, they could live off the $200,000 per year and have an effective tax rate of 0%. They would owe nothing to the Federal, state, or local governments despite earning hundreds of thousands of dollars each year. It’s enough to make Mr. Monopoly himself get excited:
Increase Your Chances for Asset Protection: Although there are no guarantees, and exceptions always exist, in bankruptcy causes the courts tend to hold a great respect for an individual’s retirement accounts, including a Roth IRA. If you are going to get wiped out or experience a major setback such as a lawsuit in which you are found liable, other than a trust fund established by a third party to which you have no withdrawal rights, a Roth IRA built up over many years is probably one of the safest places for your money if you want even the glimmer of a hope that your debts will be discharged without taking everything you hold. You may lose your home, you may lose your car, you may lose your checking account, but your Roth might – might – survive if you get a sympathetic judge.
Bypass Probate: A Roth IRA has a named beneficiary that you get to determine. That means it is more powerful than your last will and testament. In fact, if someone is listed as your beneficiary, the retirement account should bypass probate entirely upon your death and pass to the person listed with your brokerage firm or financial institution, regardless of what you say in your will, even if it is more recent
Conclusion About Investing Through a Roth IRA
The bottom line? In my opinion, investing in a Roth IRA is superior to every other form of investment holding, including outright brokerage ownership, if you are putting money away for future decades. The only major downside is that you cannot claim capital losses as tax deductions, meaning you should not be speculating or buying anything other than high grade assets that throw off surplus cash (a rule that you would be wise to consider for your entire portfolio).
There is a lot more to these plans so you should consult a qualified tax professional, such as a well regarded licensed CPA. There are ways to use IRA conversions to get around the income limits and transform an old Traditional IRA into a Roth IRA. There are ways to take advantage of self-directed options that permit you to buy real estate assets and private businesses within a Roth IRA. There are certain other exceptions, or complications, that might arise due to your individual situation that creates a unique set of circumstances not covered here (which is why I am only providing a general high-level overview to provide some familiarity with the account itself and will never provide specific advice or recommendations to anyone). At the very least, if you qualify, you should consider adding a Roth IRA to your financial toolbox as, over the decades, it can result in some phenomenal advantages.