So I recently asked a group member the other day if they knew what a Roth IRA was. They stated that they did, so I asked the following question:
"How long do you need to hold on to a Roth IRA before you are able to pull it out tax free".
She told me that you have to hold on it until your retirement age (approximately 60 years) old which partially correct. However, from this short exchange, I realized that most people (me included) understand the key words when it comes to investing, but do not understand the specifics behind those key words. Without a better understanding of these key phrases being thrown around in regards to ones retirement, we could easily make the mistake of not choosing the best vehicle for our investment. This article will hope to educate most people about the Roth IRA.
Definition
Roth IRA: an individual retirement account from which you can withdraw your earnings completely tax free any time after you reach age 59 1/2, provided your account has been open at least five years (Reference)
Possibly the biggest advantage to using the Roth IRA is that it allows you to grow your money tax-free. Yes, TAX-FREE. Let's look at the numbers to better understand how this is a benefit to you as the investor:
Scenario:
Age: 24
Starting Capital: $0
Annual Contribution: $5000
Years to Grow: 31
Retirement Age: 65
Interest Rate: 10%
Current Tax Rate: 25%
Estimated Salary: $50,000
Value at Retirement (Traditional IRA): $2,610,330
Value at Retirement (Roth IRA): $2,683,185
Difference: $72,855
Numbers do not lie and under the conditions specified above, the Roth IRA would allow you to have an extra $72,000 in your pocket at retirement, which is very useful in obtaining that Maserati that you have always wanted. For more information on how this data was calculated, please view the following link:
Financial Calculator (Roth IRA vs Traditional IRA)
For assistance in determining your tax bracket, click on the link below:
Finding out your Tax Bracket
So What's the Catch
There's a saying that if it is too good to be true, then it probably is. Well, in this case, it really is not. There are a few specifications that you must meet in order to be able to participate in the Roth IRA investment vehicle, however most middle class workers meet this criteria:
Single filers: Up to $99,000 (to qualify for a full contribution); $99,000-$114,000 (to be eligible for a partial contribution)
Joint (Married) filers: Up to $156,000 (to qualify for a full contribution); $156,000-$166,000 (to be eligible for a partial contribution)
Another important criteria to explain is that you cannot contribute more than your annual salary. For example, if you make $2000 in one year, $2000 is the maximum amount you can contribute to your Roth IRA for that year. Also, the maximum you can contribute to the Roth IRA in one year is $5000. As you can see, most people fall under these categories and are able to contribute the full amount to the Roth IRA.
Another great benefit about the Roth IRA is that all of your contributions to this fund grow tax free after you have held the fund for at least five years. However, this does not mean that you will not receive an "early withdrawal penalty" if you decide to pull your contributions out prior to retirement. In addition to that, the interest and capital gains that you withdraw from your Roth IRA are subject to a 10% tax if you begin your withdrawals prior to your retirement age (59.5). There are exceptions to this rule which will allow you to pull out Roth IRA distributions without being taxed listed below:
- Worker has become disabled and can no longer work
- Distribution for a beneficiary
- Buy, build or rebuild first home
Roth IRA Distributions
You have the facts, so why not...?
Another great benefit about the Roth IRA is that you are not forced to take the minimum distribution after you have reached age 70.5 as required by the 401(k) and other traditional IRAs. This holds a benefit that will allow your money to continue to grow tax free until you need to use it.
Now that you have been armed with new information about the Roth IRA investment vehicle, I hope you realize that the Roth IRA is a sound investment choice. Now it is time to dive head first to make the compound interest from your investment begin working for you immediately as well grow it 100% tax free! I recommend opening an account with Vanguard or TrowePrice to get started, but you are not limited to mutual funds. Please choose carefully and have fun!
As usual, if you have any comments, please leave them below.
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