Why do financial planners love Roth IRA's?
AI's response in regular print | Beverly Hills, CFP®, Joe O'Boyle's in italics
“Why do financial planners love Roth IRA’s?”
For the 2023 tax year, you may contribute up to a maximum of $6,500 to your Roth IRA. For those age 50 or older in 2023, you may contribute up to $7,500. If eligible, you have until April 15, 2024 to make the after-tax Roth contribution. Financial planners typically recommend contributing the maximum each year and investing the underlying funds in a mix of stock and bond mutual funds (or ETF’s) to allow for the potential of tax-fee growth for the long-term.
Roth IRAs: A Golden Goose for Your Golden Years
Imagine you’re starting your first job, retirement might feel like a lifetime away. However, this is actually the perfect time to get a head start on securing your financial future, and a Roth IRA is one great way to do it.
What is a Roth IRA?
Let's start with the basics. A Roth IRA (Individual Retirement Account) is a type of investment account designed to help you save and grow your money for retirement, and it comes with some excellent tax benefits. When you put money into a Roth IRA, you're depositing money you've already paid taxes on (known as "after-tax dollars"). The cool part? When you retire, you can withdraw the money you've put in and any earnings it's made 100% tax-free.
Why Financial Planners Love Roth IRA’s
Financial planners love Roth IRAs for a variety of reasons. Here are a few:
Tax-Free Growth: The earnings on your contributions grow 100% tax-free. You won't owe Uncle Sam a penny when you withdraw your money in retirement.
No Required Minimum Distributions: Unlike other retirement accounts, Roth IRAs don't have required minimum distributions (RMDs) at age 73. That means you can let your money potentially grow and compound for as long as you like. The ability to take tax-free withdrawals from a Roth IRA can also help keep your taxable income lower in retirement, possibly reducing the tax on your Social Security benefits (social security benefits can be taxable in retirement if your taxable income is above a certain threshold), further enhancing the benefits of a Roth IRA’s tax free withdrawals.
Flexibility: With a Roth IRA, you can withdraw your after-tax contributions (but not earnings) at any time without penalty, providing flexibility for emergencies.
Roth IRA Eligibility
In order to contribute to a Roth IRA:
You or your spouse must have sufficient earned income (from working).
Your Modified Adjusted Gross Income (MAGI) must fall below certain limits for the 2023 tax year. For example:
—If you are single, you can make a full Roth contribution if your MAGI is less than $138,000.
—If you’re married and file taxes jointly, you and your spouse can each a full contribution if your combined MAGI is less than $218,000.
Roth Conversion: The 'Backdoor' Strategy
Now, here's a catch. Not everyone can contribute directly to a Roth IRA due to the income limits set by the IRS. But where there's a will, there's a way! Enter the backdoor Roth conversion. This is a legal strategy that allows you to benefit from a Roth IRA, even if you earn too much to contribute directly.
Here's how it works: You first contribute after-tax money to a Traditional IRA (which doesn't have income limits for contributions), and then you convert those funds immediately to a Roth IRA. By converting the after-tax Traditional IRA dollars, you don’t have to pay taxes on the Roth conversion. The money may now grow tax-free in your Roth IRA and can be withdrawn tax-free during retirement.
Note: please consult with your financial advisor and accountant to ensure you don’t have any other pre-tax IRA assets, otherwise a pro-rata calculation will be required and a portion or all of your Roth conversion amount may be taxable to you as ordinary income.
Start Early: The Power of Time and Compound Returns
When it comes to investing, time is your best friend, thanks to something called compound returns. Compound returns are when your earnings start to earn their own earnings. You may think of a snowball rolling down a hill that gets bigger and bigger as it gathers more snow with each roll.
Let's say you invest $100, and it grows by 10% in a year. You'll have $110. If that $110 grows another 10% the next year, you'll have $121, not just $120. That extra $1 came from the $10 you earned. The earlier you start, the more time you give your money to grow, which can make a massive difference. For example, if an investment grows by 10% annually, it will double in value roughly every 7 years.
Early Earl vs. Catch-up Carl
Let's look at two hypothetical friends: Early Earl and Catch-up Carl. Each decided to open a Roth IRA, but at different times in their lives.
Early Earl starts at age 18. He contributes the maximum amount of $6,500 every year until he retires at age 65.
Catch-up Carl waits until he's 30 to start contributing. Like Earl, he also contributes the maximum of $6,500 every year until he retires at age 65.
Assuming both of their investments grow and compound at an average rate of 6% per year in their Roth IRA’s, here's where they end up:
Early Earl, with his 47 years of contributions and growth, ends up with a staggering $1.56 million that is tax-free for retirement.
Catch-up Carl, despite making the same yearly contributions, but starting 12 years later, ends up with just over $720,000 that is tax-free for retirement.
That's right. By starting his Roth contributions 12 years earlier, Early Earl has more than twice as much money in his Roth IRA at retirement compared to his friend, Catch-up Carl.
Conclusion
Roth IRA’s are a powerful tool in your financial toolbox. Financial planners love them for their flexibility, tax benefits, and long-term growth potential. By understanding and using strategies like the Roth conversion, even high earners can benefit. And by starting early, you can fully utilize the power of compound returns to secure a financially comfortable retirement.
What did you think? How did AI do?
About OpenAI’s ChatGPT tool:
GPT (short for "Generative Pre-training Transformer") is a type of language model developed by OpenAI that is trained to generate human-like text. ChatGPT is specifically designed for generating text in a conversational style. It is a machine learning model and has been trained on large datasets of real-world conversations in order to learn the patterns and styles of human communication.
Joe O'Boyle is the founder and principal of O'Boyle Wealth Management, a full service financial planning and investment management firm, located in Beverly Hills, California. Joe O’Boyle was named to InvestmentNews 40 under 40 class of 2016, and has a catalog of financial planning and investing articles on Money.com & U.S. News. Disclosure information.