The Most Powerful Tool to Plan for Retirement
In my opinion Roth IRA’s are the most powerful tool the government has given us to plan for retirement. The younger you are, the more powerful of a tool it can become. I encourage anyone looking to accumulate wealth in a tax-efficient manner to keep reading.
Roth IRA’s were established through the Taxpayer Relief Act of 1997 as a way to provide additional retirement savings tools and encourage young people to get started saving earlier. A Roth IRA is an individual retirement account that allows for after-tax contributions. Your money then grows tax deferred and, assuming certain criteria are met, it allows for tax-free withdrawals in retirement. The earlier you start, the more powerful this tool becomes. The contribution maximum is $6,000 a year, unless you are older than 50, in which case you can contribute an additional $1,000 for a total contribution of $7,000. You cannot contribute more than you made in any year. So if you earned
$4,000 a year while working part-time, you could only contribute $4,000, not the maximum of $6,000. On the flip side, there are also income thresholds that may eliminate or reduce the amount you can contribute. If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be less than $144,000. If you are married and filed jointly, your combined MAGI cannot exceed $214,000.
The compounding effect can work wonders on your investments and inside a Roth IRA it only magnifies the benefit. Roth IRA’s provide the only investment vehicle that allows you to pull out all growth tax-fee (assuming you’ve satisfied the withdrawal requirements). Warren Buffet once said, “Compound interest is the 8th wonder of the world” and I couldn’t agree more. Start contributing as early as you can and don’t stop, even if you don’t feel like you are contributing enough.
Consider this example: A 25 year old invests $500 initially and continues to add $500 monthly for the next 40 years. Assuming an 8% annualized rate of return, the account would have grown to
$1,565,201.37 and that person would have invested only $240,000 ($6,000 annually X 40 years) for a gain $1,325,201.37. If that gain was inside a Roth IRA you could pull every last dollar out and not pay one cent of tax. Check out investor.gov, they provide an easy to use compounding interest calculator that will get anyone excited to start investing.
The flexibility offered by Roth IRA’s is another feature that adds to their allure. With Traditional IRA’s if you need access to funds prior to 59 ½ you are typically subject to a 10% penalty and then you will pay income tax on the withdrawal, which can significantly reduce the net amount to you after penalties and taxes. In Roth IRA’s you can pull your contributions out at any time, for any reason with no penalty or tax owed. There are also no RMD’s (required minimum distributions) so you have full discretion to choose when and how you take withdrawals in retirement.
As long as you have earned income below the threshold, you can contribute to a Roth IRA. So if you have a job when you are younger, you can start the compounding snowball early. This also works on the flip side; if you are 75 and still working you can contribute up to $7,000 (something you can’t do with a Traditional IRA).
If you are interested in learning more about how a Roth IRA might fit in to your current investment plan, please don’t hesitate to give us a call to discuss. In future publications we will address the Roth IRA conversion and the “backdoor” Roth contribution for high income earners.
Opinions expressed are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. This is a hypothetical example for illustration purposes only. Actual investor results will vary. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period.
Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion. Investing involves risk and investors may incur a profit or a loss regardless of strategy selected.
