How to maximize the value of an investment vehicle you may already be using and make your dollars go further.
The Roth IRA is a dynamic and useful vehicle as part of a long term investment strategy. Accessible by most, it possesses both a high level of liquidity and wealth building opportunity when managed correctly. It can provide opportunities for home purchases, medical situations, and estate planning. In this post, we briefly review its history and some of the savvy ways it can be put to work. What we will not do is compare and contrast against other investment vehicles (e.g. a Traditional IRA).
Origins
The Roth IRA went into effect in 1998. Used as another tool to encourage retirement savings, Congress gave it some benefits that it had not given to the Traditional IRA or others, specifically:
- you could contribute to it for as long as you live, as long as you have earned income
- if you met the specific requirements, there are no required distributions, ever, and
- there is no income tax when withdrawn and earnings are tax-free if specific requirements are met
However, there are some issues that could arise, including:
- no ability to make contributions if your income exceeded certain levels, yet there may be a workaround
- or, if you see this as an issue, contributions not being tax deductible, as they came from after-tax dollars (see the point about no income tax, above)
These new opportunities, coupled with some of the techniques listed below, helped give rise to its popularity.
Superpowers
Inheritance
As its popularity has increased and investors have aged, the Inherited Roth IRA has become an excellent vehicle to pass wealth to non-spouse heirs. By way of:
- Avoid estate taxes. The Roth IRA is unique because it can be inherited directly by your heirs, can avoid probate, and can avoid taxes throughout the estate process.
- Tax-free withdrawals. As long as the contributions being withdrawn have been in the Roth IRA for more than the 5-year minimum, your heirs can withdraw the money tax-free. They have the option to receive it within five years of the death or have it paid out as an annuity over their life.
- Keep it growing. As mentioned above, when the heir elects to not receive all the money at once the money still in the account will continue to grow during distribution. It is possible that any money left in the account before their death would pass on to their heirs.
Jumpstart the kids
This is perhaps a non-conventional way of looking at the Roth IRA for the kids. The idea is that because there are no age restrictions on the Roth IRA, as soon as your children have earned income they are eligible to contribute.
- Contributions can be withdrawn. One overlooked aspect to the Roth IRA is that any contributions (not earnings, like interest or stock gains) can be withdrawn, for anything, at any time. Your children who contributed would be eligible to withdraw those contributions if needed.
- Down payment on their first house. Anything that has been in the account for 5 years can be taken out (up to $10,000) to buy a first home, tax, and penalty free.
- Tuition. Any earnings can be used for qualified higher education expenses. They will be taxed as earned income, but not subject to the 10% additional penalty tax (see form 590b Distributions from Individual Retirement Arrangements), referenced below.
- Their retirement. God bless the time value of money. That $5,000 that accumulated before they were 18 will be worth $64,927 at age 62, assuming a 6% rate of return.
Your avenue to wealth
Perhaps the most popular use for the Roth IRA is for yourself and that is as it should be. The features of the Roth IRA can have enormous benefit to you in your retirement.
- After tax = tax free. Having years of savings and growth through the Roth IRA at your disposal when you retire is undoubtedly a great plan. The plan is even sweeter because of the avoidance of any income taxes (as long as you met distribution rules) and withdrawing that money without penalty.
- Pre-Retirement Contribution Withdrawals. Unlike other accounts, the Roth IRA is after-tax contributions. The government honors your payment of taxes by giving you the ability to withdraw those contributions any time you would like. So say you have been contributing throughout your 30s and have $40,000 in total contributions and you want to take a European Vacation for your 40th birthday. You may take out up to $40,000 without any penalty.
- Backdoor IRA. For some, the Roth IRA doesn’t appear to be an option as they have exceeded gross income limits. Don’t fret, do some research and see if you have the ability to do a conversion, sometimes known as a ‘backdoor IRA’ that allows you to still contribute.
Andrew Grill — I write about [Life. Personal Finance. Technology. Careers.]
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Please consult your financial professional to ensure any of these options work best for you before taking action.
Sources:
Vanguard:
NerdWallet:
IRS
- Contributions to Individual Retirement Arrangements (Publication 590-A)
- Distributions from Individual Retirement Arrangements (Publication 590-B)
RothIRA.com
