How many things can you think of these days that are truly tax-free?

Not many. Here is a short list: municipal bonds, college 529 plans and Roth IRA’s. You can also save on taxes by offsetting capital gains with capital losses in your stock portfolios, although our goal with investing is to minimize the capital losses and actually grow our portfolio.

Once upon a time, many years ago, we were sold on the idea to invest in Traditional IRA’s because we could get a deduction today and when we retire, “you’ll be in a lower tax bracket”. Well, not so much anymore. Many retirees stay in the same tax bracket when they retire. Remember, when you withdraw from a qualified retirement account, meaning your contributions were before tax dollars, you are taxed on both the principle (contributions) and the gains. You haven’t paid taxes on the money you contributed, and Uncle Sam is now expecting his share.

The Roth IRA is a retirement account that allows you to contribute after tax dollars to an individual retirement account and at 59 ½ withdraw not only the contribution, but the gains completely tax free. You are contributing after tax dollars. You do not get to deduct your contribution when you make it like you can a traditional IRA, but again, when you withdraw you are keeping it all.

In summary, Traditional IRA’s help you now with taxes and Roth IRA’s help you later. A Roth IRA is a great way to fund an early retirement by having access to larger sums of money without pushing you into a higher tax bracket. This pool of money is good when you need to make a large purchase or have an expensive repair. Pulling from your Roth IRA also allows you to spread out taxable income from your traditional IRA over a longer period.

How much can you contribute to a Roth IRA each year?

$6,000 under age 50 and $7,000 if over age 50 in 2019.

Are there restrictions to how much you can contribute?

Yes, there are income limits so if you make too much money, you might be ineligible to contribute to a Roth in 2019.

If you’re single, you start phasing out of the Roth at $122,000 and at $137,000 you become ineligible to contribute.

If you’re married, you start phasing out of the Roth at $193,000 and at $203,000 you become ineligible to contribute.

Get to know the backdoor Roth IRA

Let’s say that you’re a married couple making $250,000 a year thus disqualifying you from contributing to a Roth. No worries, there is a work around. There is no income limit on doing a Roth conversion so in this example, the couple would simply contribute to a traditional IRA and then convert the traditional IRA into a Roth IRA. Keep in mind, when you do the conversion, it might create a taxable event if you have earned interest on the account. This is a great workaround for those in higher income brackets.

What makes a Roth IRA great for retiring early?

When you contribute to a Roth, you’re using after tax money.  Because you’ve already paid taxes on these funds, you’re able to reach back in and take those contributions out tax-free and penalty free at any time. That’s right, you have access to your contributions at any time. In regard to your earnings, now that’s a different story. 

Example:

Contributions:  $60,000
Account Value: $101,000

You have complete access to your $60,000 in contributions at any time. However, the $41,000 in earnings only become tax free once you are 59 ½ and have had your Roth IRA for at least five years. If you pull those funds early, they are taxed and penalized unless it’s a qualified education expense or medical hardship.  After 59 ½ all your withdrawals are tax freeIdeally, it’s best to let your Roth grow to beyond 59 ½ and make withdrawals as you need them.  However, the Roth gives a lot of flexibility if you decide to retire sooner.

Converting an existing traditional IRA

In some circumstances, it might make sense to convert an existing traditional IRA into a Roth IRA.  Generally speaking, the younger you are, the bigger the benefit.

Let’s say you’re 40 years old and you have a $100,000 traditional IRA. You could open a Roth and move your traditional IRA into it.  Keep in mind, it is taxable when you do this. You’ll pay federal and state tax on this transaction which equals a pretty large tax bill. It is best to not to use the retirement dollars to pay this bill, rather, use outside dollars to pay the taxes.  Using the retirement dollars to pay the taxes before you are 59 ½ will also tack on more taxes and a penalty. It may be best to do the conversion in smaller amounts and spread it out over several years. This makes the tax bill a little more manageable and might save you from a higher tax bracket.

Now there is a five-year Roth Conversion rule that states you must wait for five years before you can access your “contribution amount” or the $100,000 tax and penalty free.  After five years, you would have access to the $100,000 at that time. Earnings are always best to be kept in the Roth until after age 59 ½.

In the end, I’d rather my retirement account give me flexibility and hey, who doesn’t like tax free.  Roth’s will give you both of these.

Live free my friends