Learn how a Roth IRA can help young investors build incredible wealth, reduce taxes, and increase financial flexibility. Here are the top three ways this unique account can help you win the game.

Introduction

Many of my friends come to me seeking feedback around their specific personal finance situations. I tend to enjoy the boring details. But the second I start spewing facts about tax brackets, retirement planning, and hacking health insurance, their eyes begin to glaze over.

Here’s the thing, personal finance can grow as complex as you want to make it. The complexity only increases once you’ve built a significant base of assets. Like most things in life though, a few simple tweaks will take you 80% of the way.

One of the fundamental tweaks that I find myself suggesting most often: opening a Roth IRA.

Overview of the Roth IRA

Before explaining what makes it so powerful, let’s quickly define the Roth IRA and establish the basic rules that govern its use.

The Roth IRA is a type of individual retirement account (IRA) that allows people to make contributions on an after-tax basis. The investments then grow tax free. Forever.

This differs from a “traditional IRA” where investors contribute “pre-tax” dollars, reducing the amount of income that the IRS takes into account when calculating their tax bill. The tax burden simply gets deferred until retirement – investors pay the tax upon withdrawal.

The individual nature of both Roth and traditional IRA’s means that investors open these accounts independently at a brokerage firm (Charles Schwab, Vanguard, Fidelity, etc.) or bank of their choice. In contrast, many retirement accounts, like the 401K, are run through employer-sponsored plans.

Creating an individual account takes marginally more legwork. However, the payoff is worth it. Individuals gain the ability to invest in virtually any publicly traded individual stocks, bonds, index funds, REITs, commodities, and much more. All with low or no fees and some serious tax benefits over time.

Roth IRA Rules at a Glance

As with anything that the IRS touches, there are a few rules and regulations to keep in mind when opening a Roth IRA. Here’s a quick and dirty cheat sheet:

  • Maximum contribution of $6K / year (at time of this writing); $7K / year after age 50
    • Modified Adjusted Gross Income (“MAGI”) must be under $140K for individuals and $208K for couples
    • Note: investors can maneuver around this income limit with a loophole called a backdoor conversion
  • Contributions can be withdrawn penalty-free and tax-free at any time
  • Investment Gains can be withdrawn penalty-free and tax-free once you reach age 59 ½
    • However, investors can also withdraw gains with no taxes or penalties if the Roth IRA has been open for more than 5 years and the money is used for special qualified purposes including: education, medical bills, or a first-time home purchase

3 Ways the Roth IRA Can Make Millennials Rich

Tax-Free Growth and Withdrawals

They say the only sure things in life are death and taxes. While the Roth IRA can’t help on the whole death part, it can definitely help investors from a tax perspective. To reiterate my point above, gains generated through Roth IRA investments will never be taxed again.

This allows investors to ride limitless upside for the rest of their lives. And for once, Uncle Sam won’t appear at the end of the journey with his hand out. The catch here, of course, is that individuals must pay taxes on the income upfront in the year it’s earned.

But this is an advantageous tradeoff for most young professionals. Think about it like an arbitrage opportunity. The Roth IRA allows these young investors to pay taxes today, when income sits at the lowest level it ever will (assuming salary grows with increased seniority and responsibility). This means getting taxes out of the way now, when they’ll be lower than ever, and never worrying about them again.

Even if an individual doesn’t expect income to grow drastically later in life, the Roth IRA still has merit. Most people hold the bulk of their retirement assets in traditional 401Ks that are “tax-deferred.”

The Roth IRA allows investors to diversify their tax strategy. This represents a prudent course of action given uncertainty around future public policy and tax legislation. Given unprecedented government spending and budgetary constraints, it’s quite likely that tax rates will rise over time. The Roth hedges against this macro risk.

Hybrid Emergency Fund

The Roth IRA can also serve as a hybrid emergency fund. See, although its primary functionality revolves around retirement, it offers considerably more flexibility than most people realize.

First, all contributions can be withdrawn without any penalties or taxes. This means that investors can withdraw their $6K annual contribution with no strings attached.

There is no time restriction around this rule either. For example, an individual could contribute $6K for three years and withdraw the cumulative $18K in the fourth year without concern.

Now, I personally like to think of my Roth IRA funds as untouchable. The opportunity to enjoy a lifetime of tax-free growth is too compelling for me to sacrifice. But if I ever experienced a major life crisis, it’s comforting to know that my contributions sit there for me to draw down as needed.

Second, the Roth IRA offers additional flexibility once the account has been opened for more than five years.

After the five year mark, contributions and gains can be used for certain pre-established purposes without tax implications or penalty fees. These purposes include: a first-time home purchase, qualified education expenses, birth / adoption expenses, or unreimbursed medical expenses.

While no one enjoys contemplating worst-case scenarios, let’s consider one to demonstrate the Roth IRA’s power as an emergency stopgap.

Example of the Roth IRA’s Emergency Resilience

  • Lucy gets laid-off from her job in May
  • She then gets into a massive car accident in June which requires her to undergo emergency surgery
  • The car repairs cost $8k
  • Emergency surgery costs another $20K out of pocket

If needed, Lucy could use Roth IRA contributions to fund her full $8K in car repairs. Then, she could use gains and contributions to pay the $20K in qualified medical expenses.

All this while facing no tax or penalty consequences.

No Required Minimum Distributions

The final unique benefit that Roth IRA’s provide is the ability to avoid required minimum distributions (RMDs). With traditional 401Ks and IRAs, investors are required to begin making withdrawals from their accounts once they hit age 72.

Remember, these withdrawals are subject to ordinary income taxes since contributions were originally made on a pre-tax basis. This stipulation can create sticky tax situations for folks who have built particularly large traditional IRA / 401K balances.

The forced nature of these distributions limits an investors’ ability to manage taxes efficiently throughout retirement and also complicates estate planning.

Granted, there are far worse problems to have. If an investor has built pre-tax retirement accounts that are large enough to create these massive tax burdens, they’re likely in a strong position. It’s a suboptimal situation nonetheless though, and a burden that investors can ease with some proactive planning.

The Roth IRA completely eliminates the RMD concept. Investors can withdraw as much, or as little, as they would like at any time after 59 ½ (with zero tax consequences).

Beyond that, investors can also opt never to withdraw Roth IRA funds. If an individual builds enough wealth that they don’t need to use these funds throughout the course of their own life, the account becomes a powerful tool to transfer significant, tax-optimized generational wealth to heirs. Note that unlike the original investor, beneficiaries will be forced to take required distributions once they inherit the funds though.