What is a Roth IRA and How to Open Your Account
Troy Sharpe: What is a Roth IRA? How do you open a Roth IRA? What are the benefits, and should you have a Roth account?
Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, CERTIFIED FINANCIAL PLANNER™ Professional (CFP®), and host of The Retirement Income Show. The Roth IRA is one of the greatest tools you’ve been gifted by Senator William Roth in 1997, is when these came about, for saving for your future. It is one of the most powerful tools you can have in your arsenal when it comes to preparing and planning for retirement. We need to understand what Roth IRAs are, who can contribute to one, who cannot, some of the differences between your choices, and then also what do you need to know to make this the most powerful tool you can for your retirement.
You have a choice of an IRA or a Roth IRA if you want to save money outside of your company retirement plan. These are individual plans. Individual retirement account. A Roth IRA is a Roth, or think tax-free individual retirement account. If you have a 401(k) or a 403(b) or some type of workplace retirement plan, those are workplace plans, employer-sponsored plans. These are individual plans.
You can save inside your 401(k), but you could also save inside an individual retirement account or a tax-free individual retirement account. The difference between the two is that when you put money into your 401(k) or the IRA. Let’s say you have a salary of $60,000, you decide to save $5,000, you get a tax deduction, which just simply means this $5,000 savings, it reduces the amount of your income that is subject to tax.
Your taxable income in this instance, very simple example, would be $55,000. With the Roth IRA, the same $60,000 salary, if you decide to save $5,000 for your retirement into the tax-free account, your taxable income is $60,000. With the tax-free IRA, you do not get the tax deduction for making the savings into your future retirement account. Your taxable income is $60,000 so you pay taxes today on this income.
Whereas with the individual retirement account, you wouldn’t get that tax deduction and not have to pay income taxes today on the amount you save, that $5,000. The difference here is let’s say you’ve been diligent about saving and over time you’ve accumulated $100,000 inside your individual retirement account. If then you’re in retirement and you want to distribute $10,000, that $10,000 is going to be taxed at whatever tax rates are in the future.
Most people believe taxes are going to be a lot higher in the future. I don’t have a crystal ball for sure but 10, 20, 30 years from now based on the amount of money our government spends, the amount of debt that we have, it’s a very good likelihood that taxes could be higher than they are today. We’ve deferred taxes until we start taking distributions with the IRA, but you’ve taken a tax deduction upfront today.
With the Roth IRA, if you had chosen to contribute to the Roth IRA and it grows to $100,000, and in the future, you take a $10,000 distribution, that distribution is 100% tax-free. It doesn’t matter if taxes are higher, if they’re lower, you have the ability to take money out, finance your retirement, your spending, your travel, the things you want to do, and pay no income taxes whatsoever. From a planning standpoint, a lot of times it makes sense to have both of these buckets, to have some pre-tax money.
You’re taking advantage of the tax deduction today but you also want to plan for the future by creating some tax-free buckets. Everyone’s situation of course is different but understanding the concepts between the IRA and the Roth IRA, very, very important. If you’re not working with a financial planner, if you’re not working with somebody who does this every single day, you have a good understanding of the basics so you can make better decisions.
When we look at 401(k)s and 403(b)s through your employer, a lot of companies today are offering a Roth part of the 401(k). As a matter of fact, if you click on the little info icon right up here, there’s a video I did on Roth 401(k) so you can learn more about those. If this all sounds great, obviously, we love tax-free income, planning for the future, doing the right things, but these are income limits for 2020.
If you’re married and you file a joint tax return and your combined household income is above $206,000 per year, you are not eligible to contribute to the tax-free IRA, to the Roth IRA. If you’re a single filer and your income is above $139,000, you are also not eligible to contribute to a Roth IRA, but there is a workaround here. Check out my other video on the backdoor Roth conversion.
Again, clicking on the little “I” up here, and learn if your income is above these limits, some of the back door or workaround solutions that you can still contribute to a Roth IRA even if your income limits are above these but there are some caveats that you need to know. As far as putting money into from a contribution standpoint, this is what we call your contribution to your retirement plan, whatever amount you decide to save and put into either the IRA or the Roth IRA, this is your contribution amount for the year.
With the IRA or the Roth IRA, if you’re under the age of 50, the maximum annual contribution you can put into the retirement account is $6,000 per year. If you’re over the age of 50, the maximum you can put in is $7,000 per year. Your individual retirement accounts have lower contribution limits than your employer-based, your 401(k), your 403(b). Those accounts you can put a lot more income into. For 2020, I believe it’s $19,500 inside your 401(k).
If you’re over the age of 50, you get a catch-up contribution of another $6,000 per year. We have some limitations around the individual retirement accounts, primarily the amount you can contribute and also how much income you make, which determines whether you can contribute or not. These are excellent tools for saving for our future. They are long-term planning tools, the Roth IRA, and the individual IRA.
In order to take distributions from those accounts and avoid any type of penalty or bad consequence, you need to be age 59 and a half. These are retirement planning tools. With the Roth IRA, there is also a five-year rule. It’s whichever is longer. It’s five years or age 59 and a half, but when we put money into the Roth IRA, we cannot take out any of the interest that we’ve earned until the longer of aged 59 and a half or the five-year rule.
If you’re 50 years old or 40 years old, you have to wait until 59 and a half before you can touch the interest you’ve earned in this account. If you are 59 and just starting a Roth, well, then the five-year rule will apply because that is the longer of the two, 59 and a half four or five years. If you need to access your contributions, let’s say you put $5,000, $10,000, $15,000 in, and you need to access that money. No matter how old you are, if it’s been five years or not, you can go in there and access the contributions that you’ve made.
Withdrawals are done on what we call a FIFO basis, so first-in, first-out, and you can access the contributions that you’ve made without violating the age 59 rule, 59 and a half or the five-year rule. There’s a lot to learn here but these are the basics as far as a primer of understanding how IRAs, how Roth IRAs, can benefit you in your retirement. I personally believe taxes are going to be a lot higher in the future. If you’re not saving into a Roth IRA, please, consider starting, and it’s a very, very simple process to do.
What I’ve done here is I’ve pulled up a Fidelity web page, this is just fidelity.com, this is their home page. You come here to where it says open an account, your next choice is, Open a Roth IRA. Are you a Fidelity customer? No. Then you just simply enter your name and email address and hit get started. This is going to get you on the path to opening up your Roth IRA. Very, very simple process.
You then fund the account according to the contribution limits and how much you want to save for retirement, and boom, you have a Roth IRA. Very, very simple process.
Get it going, get it started, there’s no reason to procrastinate because the more you saved today, you have the most powerful investing element of all which is the power of compound interest and the power of time, working on your behalf so you can retire comfortably and have the type of lifestyle that you deserve.
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