What You Need To Know In 2021 About The Roth IRA
By David Rae, May 6, 2021, Forbes Contributor
The Roth IRA is one of the largest gifts ever bestowed upon the American taxpayers by congress. While many people ignore the Roth IRA, it has been around for more than 20 years. Even small contributions over time can grow into a substantial amount of tax-free income in retirement. Sadly, the Roth IRA is often ignored by high-income earners and the financial advisors who help them. Many earn too much money to contribute, or the lazy financial advisor just ignores the tax benefits because the contribution limits are too small to worry about for the ultra-high net worth client (so they think).
Roth IRA BASICS
A Roth IRA is a type of retirement savings account. However, unlike a Traditional IRA or 401(k), you will not receive a tax deduction when you make contributions, but your money will grow tax-free and can be withdrawn tax-free during retirement. (That's assuming you follow a few Roth IRA rules). The Roth IRA is also not subject to required minimum distributions – which means your tax-free growth can compound even longer.
The younger you are the more valuable the ROTH IRA tax benefits can be.
Contribute to a Roth When You Can. Your Income May Limit or Eliminate Your Eligibility.
The good news for procrastinators is you can contribute to a Roth IRA when you are filing your taxes for the previous year. Your Roth IRA contribution deadline for 2020 is May 17th, 2021. The sooner your Roth IRA contribution is made, the further into the future, your potential investment earnings will be sheltered from taxation. The longer your tax savings compound, the bigger the tax planning benefit of a Roth IRA.
For 2020, if you are married and filing jointly, each spouse can make a full $6,000 Roth IRA contribution if they have an AGI (adjusted gross income) of less than $196,000. For singles, that number is a bit lower at $124,000. Contribution limits drop if you earn more than these amounts, and you can't contribute at all if you are lucky enough to earn more than $206,000 as a married couple and $139,000 as a single individual. Notice, there is a marriage penalty in play here. I'm just saying.
For 2021, Roth IRA income limits have increased slightly; if you are married and filing jointly, both you and your spouse can each make a full $6,000 Roth IRA contribution if you have an AGI (adjusted gross income) of less than $198,000. For singles, that number is a bit lower at $125,000. Contribution limits drop if you earn more than these amounts, and you can't contribute at all if you are lucky enough to earn more than $208,000 as a married couple and $140,000 as a single individual.
If your income is close to the threshold limits above, consider saving the $6,000 throughout the year into a regular investment account. Then, take those funds and put the maximum you are allowed into the Roth IRA when filing taxes. Most people find it is often easier to come up with money over a year's time versus scrapping together a large lump sum at tax time.
Like A Fine Napa Wine, Roth IRAs Get Better As You Age
There are two main ways a Roth IRA gets better as you age. First, there is an allowable catch-up contribution of $1,000, per year, for those who have reached 50 years old—bringing the total contribution to $7,000 per year. On the other hand, the longer you hold a Roth, the more valuable the tax-free growth may become.
For example, if you fully funded a Roth IRA for ten years (assuming a net 10% investment return), you would have accumulated around $95,000. Whereas, if you save $6,000, per year, for 20 years, you would have around $343,000. Going a bit further, if you started contributing to a Roth IRA at 22 and kept contributing until age seventy, you could have a mind-blowing $5,760,000 on just $288,000 of contributions. Don't forget all this money can be withdrawn tax-free. So, get started as early as you can; I started funding my Roth IRA shortly after graduating from college at age 22 and before I even had a real job lined up.
Roth IRA for Spouses
A Spousal Roth IRA can help you become a Roth IRA Millionaire faster and easier. Even when one spouse doesn't work, you may still be able to open a Spousal Roth IRA. Whether your husband or wife is a stay-at-home spouse or just between jobs, a spousal contribution will allow your household to contribute to the non-earning spouse. This, of course, assumes you qualify for contributions based on the income limits.
Ignore This Roth IRA Benefit: Easy Access to Money
For those of you who are just getting started investing for the future, tying up money until you retire (decades in the future) may scare the crap out of you. What happens if you have an emergency and you need money? Roth IRA owners can withdraw their contributions after they have been in the account for five years, for any reason, without paying taxes or penalties. I mention this as a nice, friendly kick in the butt to make sure you get started saving. There is no excuse not to invest for the future. I say to ignore this Roth IRA benefit because if you use this account as a piggy bank, you will likely never accumulate enough wealth to achieve financial independence, let alone maintain a basic standard of living in retirement. Bottom line – you can touch your Roth IRA money, BUT DON'T.
The Roth IRA Five-Year Rule
To have full access to your "tax-free withdrawals," you need to fulfill the Roth IRA five-year rule. This rule means you can't withdraw your earnings, tax-free, for at least five years from the beginning of the tax year for which you made your first Roth IRA contribution. This applies even if you are older than 59 ½.
Of course, you can still pull out all your contributions at any time. If you've been saving for years and have a substantial Roth IRA, this rule shouldn't really cause much of an issue. On the other hand, if you are starting late, make sure to work with your CPA and fiduciary financial planner on a smart withdrawal strategy so you can potentially avoid unwanted taxation on your Roth IRA distributions.
The Roth IRA Double-Tax Benefit for Some Taxpayers
For once, there is a tax benefit exclusively for those in the lower income tax brackets. As I mentioned above, you don't get a tax deduction when you contribute to a Roth IRA, but you also don't have to pay taxes when you make withdrawals in retirement. (If you follow the simple Roth IRA rules.) If this isn't enough motivation, there is an extra tax bonus for low-income workers who are smart enough to make Roth IRA contributions. This bonus comes in the form of the saver's credit. If in 2021 you make less than $39,500, single, or $66,000 as a married couple, you can potentially receive a tax credit for 10-50% of your contributions to a Roth IRA. This credit is a dollar-for-dollar reduction of your taxes owed. For those who don't owe taxes, you can receive the credit as a refund.
This is like getting paid by the government to save for retirement. Your money will grow tax-free, come out tax-free, and you get a tax credit for contributing.
Just as a reminder, if you were to contribute $6,000 to a Roth IRA from the age of 22 until the age of 70, you would have contributed $288,000. Assuming a 10% annual return, your Roth IRA could potentially be worth $5,761,000. Keep in mind; this money can be withdrawn tax-free. If this isn't motivation to start a Roth IRA today, I don't know what is.
For those above the income limits to fund a Roth IRA, you may have the option to fund a Roth 401(k) at work, use the Rich Person Roth IRA, or perhaps consider the backdoor Roth IRA strategies.