Want to get excited? What if I told you there is a way to near guarantee you will retire a millionaire? If I sound like one of those charlatans who will now tell you the “Five Secrets to Stock Picking” or “How to Predict the Market”, you should recheck the site name. Unlike those methods, my method requires a great deal of time and a great deal of patience (a hint of luck also never hurt). So what is this “magical method”? First we need to discuss the primary tool of the method: the Roth IRA
I’ve continued to make hints at this mysterious “Roth” designation. You will soon see why this type of account makes it easy for someone to accumulate wealth. Deluxe RV and golf courses here we come.
- A Roth IRA is a type of investment account that allows the owner to receive tax-free qualified distributions at the age of retirement.
- The benefits of using a Roth IRA include one of the most beneficial tax treatment of all retirement accounts and the ability to contribute is limited only by the life of the owner.
- The limitations of a Roth IRA include distribution limits and contribution limits.
- The Roth IRA is arguably the easiest and most efficient way to ensure a high net worth at the age of retirement.
What is a Roth IRA?
A Roth IRA is an individual retirement account that does not allow for tax deductions, but instead allows for tax free qualified distributions. If you recall the traditional IRA or even the traditional 401k you may recall how you were allowed to take the contributions off of your taxable income for a given year. This is NOT the case for the Roth IRA. The Roth IRA forgoes this benefit in exchange for another. The primary benefit of the Roth IRA is that qualified distributions are totally tax free. Said differently the investments you make are enabled to grow totally tax free. As you can imagine, this seemingly small benefit creates a huge benefit to the investor.
What are the Benefits of a Traditional IRA?
1.Tax treatment: The Roth IRA behaves a bit differently than the traditional 401k and IRA. Those investment accounts allowed a reduction in the current year’s taxable income, but when qualified distributions were eventually made those withdrawals were taxed as regular income. In stark opposition to this the Roth IRA does not allow for a reduction in the current year’s taxable income, but instead forgoes this opportunity for a greater opportunity down the line.
Qualified distributions from a Roth IRA are tax free. This means the investments made are allowed to grow and then be withdrawn at the time of retirement completely tax free. To illustrate the astounding benefit of this let’s use a very quick example.
Say you had both a traditional and Roth IRA and by the time you reached age 60 they were each worth $1,000,000. Let’s also assume if you become $1,000,000 wealthier you will be placed in the 25% income tax bracket. If you withdraw all your funds from the traditional IRA, $250,000 of the $1,000,000 will be eaten away by taxes. Yikes. If instead you withdraw the funds from the Roth IRA, the amount of taxes you will owe is $0. The Roth allows the $1,000,000 to stay intact and does not affect your taxable income. That’s a pretty awesome deal!
2. Limited to life of owner: The other benefit of the Roth IRA over its traditional counterpart is that the “life” of the Roth IRA is only limited to the life of the initial owner. This has two implications. One implication is that while you must cease contributing to a traditional IRA at age 701/2, you can contribute to a Roth IRA till you pass away. The other implication is the lack of MRDs with a Roth IRA. A Minimum Required Distribution (MRD) is a required distribution that is a characteristic of a traditional IRA. Basically when an individual reaches age 701/2 that individual is required by law to take some amount of distribution from the traditional IRA each year. This constraint is not present in the Roth IRA.
Limitations of a Traditional IRA Plan?
1. Distribution Limitations: Delayed gratification is once again harsh mistress. Before going into too much depth it should be noted that your contributions to the Roth IRA are always distributable without tax consequence. Said differently you can withdraw the money you invested into the Roth IRA at any time and suffer no penalties. The Roth IRA has two conditions that must be met in order to receive both your contributions and the earnings that the contributions have accumulated.
- The Roth IRA must have existed for five years.
- You must be of age 591/2 or a qualified first time home buyer.
If either of the above conditions is not met, the distribution is subject to a 10% penalty tax in addition to the taxation of the earnings. Said differently if you withdrawal from the Roth IRA early, the entire benefit of the Roth IRA disappears. Be wary about early distributions.
2. Contribution Limitations: There are two limitations to contributions to the Roth IRA. The first is that your AGI (Adjusted Gross Income) must be below a certain range depending on your marital status of your tax filing. A link to the table with the 2014 values can be found here. As you can see from the table at certain income levels you may not be able to invest in a Roth IRA. Let’s assume you can. This brings us to our second limitation which is the amount you can contribute in a given year.
Your combined contribution to the Roth IRA and any other IRA account can be a max of $5,500 if younger than age 50 ($6,500 if older than 50) in a given year. To use an example suppose I have set up both a Roth IRA and traditional IRA. If I contribute $3,500 to the traditional IRA, the max amount I can contribute to the Roth IRA is $2,000 ($5,500 – $3,500 = $2,000).
No Later Taxation: An Example
For a comprehensive example let’s look at Mr. Davis who works at Apollo Inc. Mr. Davis has been contributing the $5,500 per year contribution limit in a Roth IRA account he has with a broker. Assuming that Mr. Davis has been working for 35 years the principal of his Roth IRA alone is worth $192,500 before taxes. That’s not bad, but the neat thing about that number is it’s grossly underestimating the value of the Roth IRA. Why? The money in the IRA has been invested in stocks, bonds, and other assets depending on the risk Mr. Davis took on. If we assume that he earned a 8% average return over that time period the value of his Roth IRA is not $192,500…it’s around $1,025,000 before taxes. The best part? Because the investment account was a Roth IRA Mr. Davis can withdraw that amount as a qualified distribution and owe $0 in taxes.
Mr. Davis is now a millionaire.
The Roth IRA is an amazing tool that could easily make anyone a millionaire given enough time and a somewhat favorable return on investment. The most difficult part is achieving the 8% average annual return over the time period that we assumed in the example. How to achieve that constant return? That is the billion dollar question that Wall Street brokers and financiers have been trying to solve for decades. Though I can’t guarantee a return, I can guarantee that for many people the Roth IRA is your best bet for growing a nest egg that results in you walking away a millionaire and enjoying retirement in style.
You may be wondering “How do I decide whether to put my money in a traditional or Roth IRA?”. In my next article I will tackle this subject and give you the facts to decide what type of account best suits your needs.
- Roth IRA: A type of individual investment account that forgoes immediate contribution tax deduction and instead allows the owner to receive tax-free qualified distributions at the age of retirement.
- Minimum Required Distribution (MRD): A characteristic of traditional IRAs that requires that participants must begin distributing the funds within the account once the owner reaches age 701/2.
- AGI (Adjusted Gross Income): A metric calculated by the IRS by subtracting allowable deductions from gross income from taxable sources.
- IRA Overview from IRS.gov
- Roth IRA Overview from IRS.gov
- Link to Comprehensive Website on Roth IRAs
- Comparing Roth to Traditional IRAs