When life offers you a gift, you should graciously accept it. For example, when you wake up on a bluebird powder day with green light stability, you should race up to the mountains to slay some turns. Similarly, when the government offers you a gift, you should take it and run. Don’t ask questions and don’t waste time. In the quest for financial freedom, the greatest gift the government will ever give you is the Roth IRA. EVERYONE should be contributing to a Roth IRA, starting as young as possible and continuing for as long as possible.
What is a Roth IRA?
If you are just starting your journey to financial independence, you may not be aware of the differences in the various retirement accounts available to you. We won’t go into all the details of the different retirement accounts in this post. We are only talking about the KING of all retirement accounts, which is the Roth IRA.
With a Roth IRA, you contribute AFTER-tax dollars. Your Roth will then grow tax-free with no further taxes at any point in the future, even when you eventually withdraw the money later on in your life. It’s a pretty sweet deal. The government knows this and I wouldn’t be surprised if they change the rules at some point in the future. All the more reason to start contributing to a Roth ASAP!
How to Contribute to a Roth IRA
In order to contribute to a Roth IRA, you need to have earned income. Which means you need to have a job. If you do not work for a year, you can not contribute to a Roth in that year.
If you make less than $118,000 (single) or $186,000 (married filing jointly), you can contribute directly to a Roth IRA up to the $5500 per person / year limit. Just head over to Vanguard (or Fidelity or Charles Schwab, or any other discount brokerage firm), open up a Roth IRA, and then transfer money from your checking account into your Roth IRA.
If you make more than the limits above, you can still contribute up to the $5500 limit, but you need to take an extra step, called the Backdoor Roth.
The Backdoor Roth
If you are a high income earner, here’s how you can make a full contribution to your Roth IRA:
- Open up a Traditional IRA (make sure there is $0 in your traditional IRA when you start this process)
- Contribute $5500 (after tax dollars) to your Traditional IRA
- Park the money in your Traditional IRA in a money market account
- Once the money is available for transfer (Vanguard usually places a hold of around a week), transfer the money from your traditional IRA into your Roth IRA (Called a Roth Conversion)
There are some nuances to the Backdoor Roth IRA, which have been well discussed over at the White Coat Investor. Also, tax time can be a little complicated, but if you use TurboTax, you can follow the simple step-by-step instructions over at The Finance Buff.
The Power of a Roth
Let’s say you’re ahead of the game and you have the fortune of reading this blog when you are 22 years old, fresh out of college. You contribute $5500/year, each year for the next decade and then stop.
At the end of the decade (when you are only 32 years old), you will have $72,000 of tax-free money (assuming a reasonable 5% rate of return). If you just let it grow and don’t contribute any more money to your Roth, by the time you are 65, you will have $360,000. Not bad!
But why would you stop contributing at age 32? Even if you have a really chill part-time job, you should be able to find $5500 per year to contribute until you are 65. If you keep contributing $5500 per year starting at age 22 until the time you are 65, you will have nearly 1 million dollars. And this assumes no other savings. Remember, that 1 million is particularly valuable because it is not taxed EVER AGAIN. It’s your money, all of it.
If you are more of a late starter, and didn’t figure out about the Roth until your 30’s or 40’s, you won’t have the same benefit of compounding, but you will have the benefit of no more taxes (EVER) on that money. If you look at the historical income tax rates, you will see that we currently enjoy some of the lowest federal income tax rates in history. Therefore, it would be a good bet that tax rates are going to go up in the future. However, if you have a large proportion of your portfolio in a Roth IRA, you will essentially be unaffected by higher tax rates. After all, withdrawals from a Roth IRA are tax-free!
The Catch: Roth Space is Limited
Hopefully at this point you’re convinced of the benefits of a Roth IRA. As with anything good in life, there is a catch. For a Roth, the catch is that if you don’t contribute to a Roth in any given year, you lose that special tax-protected space forever. You want to maximize your tax-protected space, and that is why you should start contributing to a Roth IRA as early as possible. You can’t go back and contribute to prior years.
One of my biggest financial regrets up to this point is not contributing to a Roth IRA earlier in my life. The first year I contributed to a Roth IRA was when I was 33. Assuming I could have contributed to a Roth as early as 15 when I mowed lawns and spread bark, I have lost out on around 15 years of potential Roth space contributions, which would be several hundred thousand tax free dollars assuming several decades of compounding. If you are reading this in your 20’s, don’t make the same mistake!
The Roth IRA, the KING of all retirement accounts, is a wonderful gift from the government. Don’t turn it down and don’t wait to contribute. If you didn’t start it in your 20’s, start NOW and keep contributing for as long as possible. It’s your only way to amass tax-free financial freedom, and it may not be around forever. Use it or lose it!
What do you think? How early did you start investing in a Roth IRA? Do you think the Roth IRA is better than tax-deferred retirement accounts like the 401k?