You may be saving for retirement via a Roth IRA without fully understanding how it works and what it can do — or you may not be using one because you don’t appreciate just how powerful it can be. Indeed, making the most of your Roth IRA might even help you retire early.
Whichever camp you’re in, you’ll likely benefit from a brief review of the Roth IRA. Here are seven facts about it that are worth knowing.
Roth IRA fact No. 1: The Roth IRA is relatively new
Your grandparents probably couldn’t have saved for retirement with a Roth IRA — though it’s much more likely that they had or have pension income than it is that you will have it. Roth IRAs were introduced as part of the Taxpayer Relief Act of 1997, with their most prominent feature being tax-free withdrawals in retirement. This is a good reminder that tax laws and possible investment strategies can change over time, sometimes getting better and sometimes worse.
Roth IRA fact No. 2: The Roth IRA isn’t the only IRA with tax benefits
There are two main kinds of IRAs — the traditional IRA and the Roth IRA — and both offer tax-advantaged ways to build your future financial security. With a traditional IRA, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes, too. (Taxable income of $70,000 and a $5,000 contribution? You’ll only report $65,000 in taxable income for the year.) The money grows in your account and is taxed at your ordinary income tax rate when you withdraw it in retirement.
With a Roth IRA, you contribute post-tax money that doesn’t reduce your taxable income at all in the contribution year. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income remains $70,000 for the year.) Here’s why the Roth IRA is a big deal, though: Your money grows in the account until you withdraw it in retirement — tax free.
So while one kind of IRA offers an upfront tax break, the other offers a back-end one. In many cases the Roth IRA will provide the greatest savings, but sometimes a traditional IRA is the better choice.
Roth IRA fact No. 3: Roth IRA contributions must be made with earned money
If you’re a teenager who wants to sock away $500 you got for your birthday in a Roth IRA, you’re out of luck. Roth IRA contributions must be made with earned money. There’s no minimum age for opening a Roth, but anyone funding their Roth IRA, whether child or adult, must do so with earned income. For kids, allowance or birthday money doesn’t qualify, but cash earned through babysitting or odd jobs can. For adults, qualified earnings include wages, commissions, and even alimony payments, but not inheritances, Social Security benefits, or pension or disability income.
Roth IRA fact No. 4: You can sock away up to $5,500 or $6,500 in an IRA
The contribution limit for all IRAs in 2017 is $5,500, plus an additional $1,000 for those 50 or older. That’s a combined maximum contribution, so if you have three IRA accounts, you might contribute $1,000 to one, $2,000 to another, and $3,500 to a third — if you’re 50 or older.
The limits increase over time, so expect higher ones in the future. In 2000, you could contribute only $2,000 to an IRA, while in 2002 you could sock away $3,000 — plus an additional $500 if you were 50 or older. The current limit has been in place since 2013.
Roth IRA fact No. 5: You can amass a surprising sum in a Roth IRA
Contributing $5,500 annually to a retirement account doesn’t seem like a recipe for riches, but you can build a surprisingly hefty war chest that way. The more you park in your Roth IRA each year, the more dollars you’ll have that can grow for you. Remember, too, that your earliest invested dollars can do the most for you, as they’ll have the most time in which to grow. Check out the following table, showing how much you might amass investing $4,500 versus $5,500 each year:
|Growing at 8% For:||$4,500 Invested Annually||$5,500 Invested Annually|
You can see how powerful time is by looking at how much more rapidly the sums grow in later years. Note, too, how much of a difference it can make to invest an additional $1,000 each year — in this example, $5,500 instead of $4,500. If you’re old enough to contribute the $6,500 allowed for those 50 and older, aim to do so.
Roth IRA fact No. 6: How you invest in your Roth IRA matters
While 401(k)s often limit your investment choices to a modest suite of mutual funds, you can invest in all kinds of securities through your Roth IRA. Some make more sense than others, though. For example, there’s little point to investing in municipal bonds in a Roth, since they’re typically already tax-exempt. Low-interest rate CDs and slow-growing stocks are also not ideal.
It can be effective to park Roth IRA money (at least some of it) in stocks you expect to be your fastest growers — especially if you’re a long way to retirement. If a stock averages 15% growth per year for 25 years, a single $5,000 initial investment can turn into about $165,000. Better still, fully $160,000 of it will be a capital gain — on which you pay no taxes, if you withdraw following the rules.
Real estate investment trusts are also good for Roth IRAs. They tend to generate a lot of dividend income, but much or all of that is often not eligible for the low long-term capital gains tax rate and is instead taxed at your ordinary income tax rate. In a Roth, there can be no tax at all. You can also do quite well just investing in a broad-market index fund or two, or a target-date fund, in your Roth IRA. Such a simple approach can be very effective.
The following table highlights the importance of your growth rate over time. It shows how much you might amass with $5,500 annual investments:
|$5,500 Invested Annually For:||Growing at 6%||Growing at 8%||Growing at 10%|
Roth IRA fact No. 7: You can convert a traditional IRA into a Roth IRA
Finally, know that if you have money in a traditional IRA, you can probably convert that IRA into a Roth IRA — a tactic that makes particularly good sense for some people, such as those with relatively small accounts and many years until retirement.
Converting a traditional IRA into a Roth means you’ll face a tax hit, as the money you’re converting has avoided taxes so far but will be going into an account funded with post-tax money. If you’re converting $150,000, you’ll be recognizing that as taxable income in the year of conversion, and it can result in a big tax hit. You’ll have to decide whether the tax hit is likely to be worth it. Conversions can be especially effective after a market crash or correction, as the sum you’re converting will be smaller.
You can roll over 401(k) funds into an IRA, too, when you change a job.
Don’t overlook the power of a Roth IRA, as it can give you more financial security in retirement — and possibly hundreds of thousands of dollars in tax-free withdrawals!