Roth IRAs are now the center of a young person's financial plan, and they've only been around since 1997. Young people especially should funnel as much money into Roths as they can. Why are they so great? Because you save on taxes.. actually you save a small fortune on taxes. Remember those capital gains taxes we covered last month that cut into your gains? Waving the magic Roth IRA wand makes those taxes disappear entirely. A Roth IRA works by contributing post-tax money to the account. Post-tax money is the net pay you pocket from a paycheck, which can also be thought of as dollars in your pocket. Those post-tax dollars can be added to a Roth IRA to buy investments like stocks and bonds. Roth IRA investments grow tax-free, and when you retire, you can take money out, also completely tax-free. By comparison, a Traditional IRA works by contributing pre-tax money. Pre-tax money is taken from your total gross pay from a paycheck before income, state, and local taxes are assessed. A Traditional IRA's dollars can also buy things like stock and bonds, but you have to pay tax on the gains when you take money out of the account in retirement. Traditional IRAs let you deduct contributions from your taxes, whereas a Roth IRA does not. You can read more about different financial account types here.
In short, with a Roth IRA, you already paid some taxes on the cash you add to the account, but those dollars can grow tax-free forever. With a Traditional IRA, you skip paying taxes upfront and deduct the amount contributed, but the money's growth gets taxed when you retire.
Roth IRA Federal Rules
- All gains from Roth investments are tax-free.
- People under age 49 can contribute a max of $6,000* each year (over 50 can contribute a little more)
- As a single person, if your income is $140,000* or more (as of 2021), you cannot contribute to a Roth that year. (There are higher limits for married people)
*dollar limits increase every few years to keep up with inflation
Major Loophole around the Rules
Anyone can use what's called a "backdoor Roth," or more technically, a "Traditional IRA Conversion," to get around both the $6000 annual maximum AND the $140,000 income limit. I had no idea this existed since it was pretty clearly against the rules until I hired a CFP (certified financial planner) in 2017. Financially speaking, hiring that CFP was easily the best $3,000 I've ever spent. How a "backdoor Roth" works:
- Have both a traditional IRA account (with money already in it) and a Roth IRA account
- Ask your account custodian (e.g., Vanguard, TD, Schwab, etc.) to move money from your traditional IRA to your Roth IRA as a conversion. (Not as a contribution)
The only catch is that the dollar amount of the conversion gets added to your gross income for that year's tax returns. This is because the dollars you are moving from the Traditional IRA were pre-tax, so government taxes were never collected on them, and they are moving to a Roth, which is post-tax. So basically, the way to "fix" those pre-tax dollars into post-tax dollars is to pay your regular income taxes once for that tax year. Because of this catch, a Traditional IRA conversion makes more sense for younger people because they have more years before retirement for their Roth IRA money to grow and offset the tax bill that comes with this conversion. This advanced method of a "backdoor Roth" is one of the ways PayPal co-founder Peter Thiel has a Roth IRA worth $5 Billion. I do not have a billion dollars, but my CFP helped me calculate and execute a conversion of $90k from my traditional IRA into my Roth in a single year when my income was artificially low due to a return to full-time school. Did paying something like $18k in taxes on that conversion hurt a bit? Sure, it did. But knowing that $90k will grow tax-free forever is an incredible feeling. Besides, at the 10% average annual return in the stock market over two years, $90k will grow to $108k, completely offsetting the $18k tax bill.
Bottom Line: Use a Roth IRA !!
- Nick bought 4 shares of Coinbase (COIN), the biggest US cryptocurrency exchange, for about $900.
- Caitlin bought 8 shares of ORSTED A/S ADR (DNNGY), a Danish renewable energy company, for $437.
- Bryan bought 71 shares of Ford Motor (F), the original American car company, for $1000.
- Brenna, Spencer, Lindsay, Chloe, Antonio, Michael, Connor, and Garrett are still sitting on the additional $1000 in cash. Please remember to update the google sheet detail tab when you buy/sell something. I look at the revision history each month so I can include your trade in this newsletter. The summary tab is at the bottom of this email as a picture and the live link to it is here.