When I was a Boy Scout, my utility knife was a prized possession. These sleek, efficient, high-functioning devices seemed to be able to do everything--especially when it came to "roughing it" in the great outdoors. Pocket knife? Check. Phillips head screwdriver? Got it. Corkscrew for popping a cork from a bottle of champagne? Um...yeah, I guess that’s there, too.
Like utility knives, there are a few investment tools that are relatively simple in their design and extremely powerful in their effectiveness. One of these, without question, is the Roth IRA.
Here are three attributes--utilities if you will--which make a Roth IRA such a powerful tool for families to build and use their wealth.
UTILITY #1 - WEALTH BUILDING WITH BENEFITS
Invest Your Money For Growth
Like other tax-advantaged investment accounts, Roth IRAs have been valuable in helping fill the void left by the disappearance of many company-sponsored pension plans. For many families, the terms are quite generous.
Maximum Roth IRA contributions in 2017 are $5,500. For investors over 50, the limit increases an extra $1,000 to $6,500. Married couples (filing jointly) earning less than $186,000 in 2017 can contribute.
While a Roth IRA doesn’t have the high contribution maximums and non-existent income restrictions of a 401k, it’s still nothing to turn up your nose at.
Assuming an 8% rate of return, an investor contributing the maximum amount to their Roth IRA each year for 35 years could have about $1.5 million by the time they retire. That sum alone is enough to fund many American families’ retirement, allowing them to draw an annual income of around $60,000.
A Wide Variety of Investment Options
Many Roth IRAs are held at brokerage firms--companies like Fidelity, Vanguard, Charles Schwab and many others. Roth IRAs held at brokerage companies have a wide variety of investment choices. Instead of being limited to 20-30 choices of mutual funds in your 401(k)--and many of them poor choices at that--investors have access to a nearly endless variety of investment options, from stocks and bonds to mutual funds and ETFs.
But a limitless supply of investment choices isn’t always best thing for investors. Stock picking has put many investors in deep water. A well-diversified portfolio is essential to long-term investing, so it’s best to stick with a simple portfolio of a few low-cost, well-diversified mutual funds or ETFs aligned with your goals and risk tolerance.
Automate Your Roth IRA Contributions
Finally, most online brokers allow you to set up automatic contributions from your checking accout into your Roth IRA. I’ve done this through my personal investment accounts. It’s a big time saver, but it helps us correct my own bad behavior, too.
When contributions are not automated it’s far easier for families to let other spending priorities get in the way (and many of these priorities aren’t good ones). Automating your Roth IRA contributions prevents your money from ever hitting your spending account in the first place. The money’s just gone.
UTILITY #2 - ACCESS TO CASH FLOW
Withdrawing Your Roth IRA Contributions Penalty Free
While you cannot take out the amount of money that’s grown in your Roth IRA, you are allowed to withdraw your “basis,” or the base amount of money you’ve put into the plan. Other tax-advantaged retirement accounts will demand a 10% penalty for this withdrawal, but not the Roth IRA.
For example, if you’ve contributed $50,000 to your Roth IRA over the last 10 years and the total account value is $75,000, you can take out your basis of $50,000 anytime you want for any purpose. Withdrawing any of the amount above $50,000 (your gains) will result in a 10% penalty, assuming you haven't reached age 59 1/2.
This can be an extremely flexible, readily accessible source of cash. Unlike an insurance policy with cash value, you won’t need to pay interest for borrowing the money or suffer any adverse premium funding issues. Unlike a savings account, your Roth IRA money can still be at work in the market potentially earning greater gains (until you take it out, of course).
Roth IRA Withdrawals for Education Costs or a First-Time Home Purchase
In addition to withdrawing your basis, withdrawals of basis, earnings or both can be done for certain qualified expenses. Two of the biggest are to cover college expenses or a first-time home purchase. In both cases, you can withdraw your basis and your earnings without being penalized. You will owe income taxes on the earnings you withdraw, but as with the previous point, your basis is yours for whatever you want--penalty free.
Above all, remember your Roth IRA is first a foremost an investment tool. If you don’t have any other investment accounts funding your future retirement I would strongly discourage withdrawing your Roth IRA contributions or earnings; however, if you find yourself in an emergency and other funding options are unavailable, doing so is a viable option.
UTILITY #3 - SIGNIFICANT TAX ADVANTAGES
After-tax contributions mean no taxation guesswork in the future
One of my biggest pet peeves is when I have a plan for my day and something unexpected comes up, completely throwing me off schedule. Of course, some emergencies are unavoidable, but I like being able to anticipate change as much as possible.
A Roth IRA gives taxpayers the ability to make a decision in the present about what they will pay in taxes rather than assuming taxes will be better or worse at some point in the future.
By essentially paying your taxes now (since Roth IRA contributions are made from after-tax income) you lock in the amount of taxes you’ve paid. With your tax bill covered, any amount you collect from your Roth IRA in the future will be tax-free.
Whether the U.S. tax climate will change in the future is unknown and impossible to plan for. Most Traditional IRA investors anticipate their taxes being lower when they retire and their income is less, therefore they choose to make pre-tax contributions and pay their taxes later. This may be the case, but it’s still an uncertainty. The tax-advantage of Roth IRAs is they allow you to plan around your personal tax situation today rather than tomorrow.
No required withdrawals during your lifetime
Traditional IRAs require account holders to begin distributions at age 70 1/2 . This requirement often comes in the form of a Required Minimum Distribution (RMD) which is the minimum amount that must be withdrawn from the IRA (amounts exceeding your RMD are fine).
The challenge is that Traditional IRA distributions require you to pay federal and state income taxes. Depending on your other sources of income--wages, social security, or 1099 income--these distributions, if not carefully planned, can affect the total taxes your family will owe by potentially pushing you into higher income tax brackets.
With Roth IRAs there are no RMDs, so the need to tactfully think about withdrawal strategies for tax purposes is greatly decreased. Once the time comes to take money from your Roth IRA to cover your expenses in retirement, you can have confidence that your tax picture won’t be changed by doing so.
In summary, Roth IRAs are indeed a powerful tool for wealth building. The majority of families can open a Roth IRA tomorrow and get started. Take some time to consider--among your other investment options--how a Roth IRA may fit into your financial picture. For many, the advantages are too hard to ignore.
Have you opened a Roth IRA? What benefits have you noticed? What has your experience been handling the different “utilities” of the Roth IRA? I’d love to hear your thoughts in the comments below.