Roth IRAs
Imagine this: Fred took started diligently investing in Total Stock Market Index Funds in his early twenties. Fred grew an investment account from $100 to over a million by the time he retired. At 65, he thinks, “wow, I invested like a pro my whole life, and now it is time to reap the rewards.” Fred decides he wants to sell all his stock market investments and go buy an island to spend the rest of his life drinking margaritas on his own private beach. He sells his holdings, only to find out he is getting hit with a 38% income tax based on his income bracket. Frustrated, he decides to gamble it all away at the casino now that his tropical, island-life dreams are ruined.
However, it didn’t have to be this way.
Thanks to Individual Retirement Accounts (IRAs), the federal government offers an opportunity to grow a portion of your investments with tax advantages using an IRA. The government offers these IRAs to encourage and financially incentivize people to plan for retirement. There are different types of IRAs, however, for the purposes of this article, I will focus on the most popular type for younger people: Roth IRAs. A Roth IRA allows any person (18 or older, otherwise a legal guardian will be required) to grow up to $6,000 of earned income a year tax-free. So if Fred had been the diligent investor that he was, but stored some money in a Roth IRA, he may have been able to afford that island.
How it Works
Many popular banks and investment brokerages offer Roth IRA accounts. They are very easy to set up and take the same amount of time as any regular savings account. I personally use Vanguard: while their platform seems a little outdated, they have some of the lowest fees and offer an awesome range of services. After you have an account set up, it is time to fund it. Vanguard does not require a minimum balance to fund a Roth IRA, and you can add up to the federal maximum set at $6,000. There are a couple of things to keep in mind though when funding your Roth IRA:
You can only invest the income that you earned from work. You can only invest what is considered “taxable income” and not from a savings account or a gift from someone else.
Once you make your contribution, it will be taxed at your income bracket. How this type of IRA works is you pay taxes now and can sell your holdings once you’re at least 59 and a half (when they are presumably worth much more) tax-free.
Unlike a Traditional IRA, your contributions are not tax-deductible.
Once the account is funded, it is important to keep in mind that the money is not yet invested. Think of the account as the medium that you use to invest. To actually invest in the account, I would recommend you check out my article on index fund investing as that is the primary investment you should be making for long-term planning. After the account is funded and the cash is invested through the Roth IRA account, all you need to do is continue to contribute to that account annually until you are ready for retirement.
If it seems too good to be true…
It might be, but not as bad. The catch with a Roth IRA is that you need to hold the money in the account until you are at least 59 and a half. The reason for this is that the government offers these tax-advantaged accounts to incentivize people to plan for their future retirement. If you were to withdraw money from the account (which you never ever should), the account would be hit with a 10% penalty AND you would have to pay taxes on the account based on your regular income tax brackets. This could mean taxes and fees of up to 40-50% of the entire account’s value. There are a few exceptions; you can withdraw the original contributions without penalty, just not the earnings. You may also pay for a few specific exceptions such as education, medical expenses, and others, but look into the specific rules of each withdrawal before doing so.
“I am a high roller… $6,000 is too little”
Well good for you, but investing $6,000 a year into a total stock index fun until retirement can lead to some huge returns. Using a compound interest calculator, $6,000 invested annually in a Roth IRA (returning the market average return of 8%) can lead to an accumulation of over 1.6 million dollars. You also don’t need to take that money out right away, for leaving it in there for another 10 years could grow the account to over $3.5 million. Not to mention that you don’t need to solely fund an index fund. You can invest more additional dollars in a regular investment brokerage account, and just accept that taxes will be taken out once you sell your holdings.
Roth IRAs are an incredible tool that everyone needs to start using, no matter the amount they have available to invest. You can’t go back in time and invest money in previous years, so you will only hurt yourself by waiting.
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