Everyone should take advantage of the IRA. It has magical properties, none more important growth. You invest today, you have more tomorrow. Which type is right for you? I will break down why I changed mine.
When you know better you do better.
Everyone should be allowed to change their mind when they get new and better information.
I have been funding my ROTH IRA now for about 2 years. So I currently have about $6,000 saved up. Right now, 2020, the yearly limit for someone under 50 years old is $6,000, $7,000 if you are older than 50. They cap it at that amount because the account is so attractive. You pay tax on the money you put into the account today as ordinary income and then you can withdraw the principal you contribute to the account at anytime after with no penalty.
Earnings are a different story. Hopefully you invest the money in your ROTH into an index and you set it and forget about it. That money will start to grow and grow over time. With a ROTH if you withdraw your earnings before 59 1/2 then you will be subject to taxes and penalties. Click here for the ROTH rules according to the IRS. There are special situations when you can withdraw ROTH earnings without paying the penalty.
The ROTH is great if you ever the need the principal that you invest in the account. The ROTH can basically act as a bank account for you. The account is also great if you plan on keeping your money invested till you reach retirement. That money can also be withdrawn upon retirement as income tax free. There are very few ways to get around paying tax on any type of personal income.
For most people this is great and the best option. Because most people will probably need the money at some point. They won’t have an emergency fund. They will have some type of catastrophic emergency where they need that money. Who the hell would have thought a worldwide pandemic would destroy everything and the US would be the country in the worst shape to handle it. But here we are.
Most people sleep better knowing they have access to more cash than they might currently need.
If you want to maximize your earnings and you are chasing financial freedom there is a better option for you, the traditional IRA. The traditional IRA acts like a 401k. It has the contribution limits as the ROTH IRA. But the money is tax deductible from your income. Meaning that you put the money away today without paying tax and then when you retire and withdraw the money it is taxed as ordinary income.
The idea is that when you retire, your income will immediately drop to zero and therefore you will be in the lowest tax bracket. You can control to some degree your tax deferred withdrawals so that you stay in a low tax bracket and pay less taxes than you would working a full time job.
But what if you do not want to pay any taxes?
- Max out your contributions to your 401k and Traditional IRA. Open a ROTH account in order to have it ready when you need it.
- Convert your funds from the traditional IRA to the ROTH IRA and pay the tax.
- Wait 5 years after the conversion. You may need to convert money every year in order to withdraw money each year in the future.
- The 2020 standard deduction is 12,400. If you withdraw less than that you do not pay any tax on that amount. If you can take more deductions you can withdraw convert more money from the Traditional to the ROTH without paying tax on that money.
If you plan carefully you can dramatically lower your tax bill and keep that extra money.
Since you defer the tax payment in the traditional IRA your principal should grow larger, because there is more money in the bucket to compound over time. The lower your taxes and fees the more money you get to keep and decide how it is used.
People pursuing financial independence should strive to max out all of their tax-deferred accounts available.
- Traditional IRA, SEP IRA
These lowers your taxable income and the higher income you earn the more tax deferrals you need. These accounts are also vehicles you are going to use for investment. This is money that you are saving rather than spending and putting to work toward your future.
People seeking financial independence have think about their life different from the average person. They have to be willing to sacrifice funds today for the promise of tomorrow. It is a gamble. Tomorrow is not guaranteed.
I am gambling that 50 years from now the United States and other democratic countries will exist and they will have bigger economies than they have today. So if you simply invest in VTI or VTSAX you have a good chance of your money being worth more in the future than it is today.
I am looking at my current ROTH IRA as an emergency fund. And I am happy that I made an investment into that. But I also opened a traditional IRA and will be funding that from now on.
If you are anything like me you procrastinate. I procrastinate. Some things I am really good at completing immediately and then other I dread and put off. But you cannot procrastinate with money. Because time really is money. The longer your money is invest the more that will accumulate.
So stop procrastinating. Fund your emergency account. Pay off your debt. Or just make a plan to get your priorities done. Your future self is depending on it.