A Roth IRA is a type of individual retirement account (IRA) that gives special tax advantages in retirement. Your contributions are made with after-tax dollars, money you've already paid income taxes on. You don't get a tax-deduction when you contribute, but your withdrawals in retirement are completely tax-free.
Comparatively, a traditional IRA gives you immediate tax advantages when you make contributions. When you put money into a traditional IRA, the amount you put in gets deducted from your taxable income for the year. The money compounds in your account tax-free until retirement. You can start taking qualified distributions at the age of 59½, which would then get taxed as regular income.
When you put money into a Roth IRA, you do so with money that you already paid income taxes on.
For example, if you made $80,000 this year and want to contribute $5,000 to a Roth IRA, you would pay taxes on $80,000 worth of income. You get no tax deductions as you would with a traditional IRA. However, because you already paid taxes on the money when you contributed, withdrawals from your account in retirement are completely tax-free.
The tax-free withdrawals is the main benefit of a Roth IRA. No matter how much money your investments make, you don’t owe any taxes.
One of the best examples is Peter Thiel purchasing his founders shares in PayPal through his Roth IRA. As a founder, he only paid $1,700 for 1.7 million shares of PayPal. In 3 years, PayPal went public, was acquired by eBay, and his 1.7 million shares was now worth $28.5 million.
Peter went on to sell those shares, but still kept all the money in his Roth IRA, not making any withdrawals. Because a Roth IRA has tax-free compounding, he still didn’t owe any taxes on the gains and was free to reinvest the entire amount. He reinvested the money into other startups like Facebook and Palantir. Twenty years after his initial $1,700 deposit into his Roth IRA, his account value was worth over $5 billion.
Because a Roth IRA has tax-free withdrawals, the entire amount could be withdrawn tax-free – not a single cent was owed to the IRS.
A Roth IRA has different withdrawal rules from other retirement accounts. With other plans, you're not allowed to take any of the money out until you reach the age of 59½. Any early withdrawals before you turn 59½ are hit with an early distribution penalty of 10% and income taxes on the amount withdrawn.
With a Roth IRA, you're allowed to withdraw your contributions at any age, without penalties or taxes. To withdraw earnings in your account, you must wait until you're 59½ years old and your Roth IRA must be at least 5 years old.
Continuing with the Peter Thiel example, he only contributed $1,700 in his Roth IRA. The rest of the $5 billion was all earnings he made from investing the money. Technically, he could have withdrawn $1,700 from his account at any time without penalties or taxes. If he wanted to withdraw anything else, it would count as withdrawals of earnings and he would be hit with a 10% penalty plus income taxes.
When does the 5 year clock start?
The 5-year clock of a Roth IRA starts on January 1 of the year you make your first contribution. For example, if you make your first Roth IRA contribution on December 15th of 2020, your clock starts on January 1st of 2020.
In addition to the unique rule of being able to withdraw your contributions, the Roth IRA is also the only account that doesn't have required minimum distributions.
With any other retirement account, you're obligated to start distributions from your account when you reach the age of 72. A Roth IRA has no RMDs. You are not obligated to take distributions while you are still alive. This makes a Roth IRA a great vehicle for passing money down to your beneficiaries, as they are still allowed to withdraw the money tax-free after they inherit the account.
Anyone who earns taxable income is eligible for a Roth IRA, as long as your income doesn't exceed the Roth IRA income limits. If you make too much money, you're not allowed to contribute to a Roth IRA at all. There are no age limits, and no minimum income limits. You could be 12 years old, making $100 a week from a paper route, and still be eligible to contribute to a Roth IRA.
If your income is too high and you're not allowed to contribute to a Roth IRA, you can do a backdoor Roth conversion by contributing to a traditional IRA and then converting the funds into your Roth IRA. The income limits of a Roth IRA restrict contributions only, conversions are not bound by income limits.
Alternatively, you could also do a mega backdoor Roth IRA and contribute even more money into a Roth IRA by using a special after-tax account and doing a rollover. This is more complicating, and you'll need to have either a 401k or solo 401k that specifically allows the mega backdoor Roth IRA.
Unfortunately, a Roth IRA has one of the lowest contribution limits of any retirement plan.
For 2022, the Roth IRA contribution limit is $6,000 or $7,000 if you're at least 50 years of age.
For 2023, the Roth IRA contribution limit is $6,500 or $7,500 if you're at least 50 years of age.
In comparison, a Roth 401k or a Roth solo 401k has a contribution limits of $20,500 in 2022 and $22,500 in 2023. If you're at least 50 years of age, your contribution limits are even higher at $27,000 for 2022 and $30,000 for 2023.
A typical Roth IRA will let you invest in securities like individual stocks, bonds, mutual funds, and ETFs. It depends on what your plan provider offers within their plans.
The IRS also lets you invest in alternative assets with a Roth IRA. You can invest in things like crypto, real estate, private equity, and even invest in startups like Peter Thiel did with his PayPal shares.
However, to invest in alternative assets with a Roth IRA, you'll need to open a self-directed Roth IRA.
The main difference between a Roth IRA and a traditional IRA is when they get taxed. A traditional IRA gets funded with pre-tax dollars. You get a tax-deduction when you contribute, reducing your taxable income for the year. The downside is that you have to pay regular income tax on the money when you make withdrawals in retirement. With a Roth IRA, you don't get a tax break up front. Contributions are taxed as regular income, but your withdrawals in retirement are completely tax-free.
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