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Investing Fundamental #6 – Roth IRA

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If you don’t have a Roth IRA account, you should open one to give yourself the more options in the future. Open an E*TRADE Roth IRA. No Fees. No minimums and get up to $600 when you rollover or transfer.

April 17th is the last day to file the 2011 tax return and you can still contribute to the 2011 Roth IRA if you haven’t already done so. If you have any extra money or got early tax refund, this would be a great time to put some away in the Roth IRA for retirement.

Roth IRA is an Individual Retirement Account.  This account in tandem with the 401k is the easiest way to grow a workingman’s  retirement portfolio.

Contributions to Roth IRA are made with after-tax dollars so there are no pre-tax benefits like the 401k. Once you reach 59 1/2, you will not have to pay any tax when you draw money from this account (aka. take distribution.) More on distribution at the end of the post.

Most people qualify to contribute to Roth IRA and here are the rules:

  • Earned Income – The contribution to Roth IRA must be from earned income. This mean if you didn’t “earn money” this year, then you can’t contribute to the Roth IRA.  Earned income is money earned from working for someone or yourself and it includes salary, wages, tips, and other active income.  You can not use unearned income to contribute to the Roth IRA.  Unearned income usually comes from investments such as interest, dividend, rental income, gifts, and capital gains.
  • Income Limits – If your AGI (adjusted gross income) is too high, the IRS will limit your Roth IRA contribution.  In 2011, if your AGI is more than $179,000 (joint) then you can not contribute to Roth IRA.  There is a linear phaseout area between 169k to 179k.  The phaseout region for Single and Head of Household is from $107,000 to $122,000.   Check the IRS website if you make more than six figures.
  • Contribution Limits – You can contribute $5,000 per calendar year if you’re younger than 50 and $6,000 if you’re older.

Personally, I like Roth IRA quite a bit. It is easy to open a Roth IRA account at a discount brokerage.  You can buy any stock, mutual fund, or bonds that you like.  There are no restrictions like in your 401k account.

retirebyforty’s Roth IRA strategy

> MAX out your 401k contribution first before contributing to Roth IRA.

> Open a Roth IRA account at a discount brokerage to avoid high fees.

> Contribute the max to Roth IRA.  I contribute $5,000 once a year, but you can also set up a monthly auto-transfer for $5,000/12 to take advantage of dollar cost averaging.

> Since the Roth IRA grows tax free, I would put the more high risk high reward investments in this account.  This is a good spot for small cap funds and high growth individual stocks especially if your investment time line is long.

> Don’t withdraw until after 59.5 years old to maximize compound investing, avoid tax and possible 10% penalty. *see below*

> If your child earned over $5,000 this year, it could be a good idea to gift $5,000 toward the child’s Roth IRA if you can afford it.  The earlier you start investing, the better off you’ll be in the future.

Are you contributing to a Roth IRA?  Don’t miss out on this great investment opportunity.

Roth IRA Distribution

You can withdraw your contribution(money you invested) at anytime with no penalty. I don’t recommend this though because we want to let the investment compound. You can also take early distribution on the gain if you need, but you may have to pay a tax and possibly penalty. Here is a nice flow chart from the IRS. You can see this IRS page for all the gritty details.

irs roth ira early distribution flow chart

Exceptions. You may not have to pay the 10% additional tax in the following situations.

  • The distributions are part of a series of substantially equal payments.
  • You have significant unreimbursed medical expenses (over 7.5% of your AGI.)
  • You are paying medical insurance premiums after losing your job.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.

If you don’t have a Roth IRA account, you should open one to give yourself the more options in the future. Open an E*TRADE Roth IRA. No Fees. No minimums and get up to $600 when you rollover or transfer.

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{ 34 comments… add one }

  • Invest It Wisely November 22, 2010, 12:09 pm

    I think the Canadian TFSA is similar to a Roth IRA, but the good thing is that there is no age limit on withdrawals: It really is simply a tax-free savings account. This could be good for early retirement.

    • retirebyforty November 22, 2010, 12:27 pm

      Oh wow! I like the TFSA even more than ROTH IRA then. It would be tempting to withdraw it sooner though. I wouldn’t draw on any 401k or IRA unless it is really really the last resort. I hate paying fee and penalty. 🙂

    • 101 Centavos April 15, 2011, 5:13 am

      Would the TFSA be one of the reasons for a higher incidence of dividend paying stocks in Canada?

  • Robert Muir November 22, 2010, 1:11 pm

    With the Roth, you can withdraw contributions (not gains) without penalty after 5 years. Still, I wouldn’t do it unless there was no other option.

    • retirebyforty November 22, 2010, 9:30 pm

      I didn’t know that. Thank you for the info, I copied your comment and put it up in the post above to make sure people see this. I’ve been concentrating on add to ROTH IRA and haven’t look at withdrawal rule much.

    • Money Reasons April 13, 2011, 6:11 pm

      Actually I believe you can withdraw contributions at any time, not just after 5 years. But you can’t withdraw gains until you are 59 1/2 years of age (for the 1/2 don’t ask me why).

  • Barb Friedberg November 22, 2010, 5:50 pm

    I have contributed to a Roth since it’s inception. Additionally, we max out our workplace retirement accounts. The Roth is an outstanding investment opportunity given the likelihood that taxes in the future will be higher than they are today!

  • Aloysa November 22, 2010, 7:39 pm

    I am thinking about Roth but there are some other issues we need to work out first. great summary, BTW. Very useful. I liked your plan, too. I might steal your ideas when we are ready to open Roth. 🙂

  • Moneycone November 23, 2010, 3:47 am

    retireby40, contributions can be withdrawn anytime, only the earnings have an early withdrawal penalty.

    Roth can also be used to purchase your first home without penalty (but with certain restrictions).

  • Kevin @ Thousandaire.com November 24, 2010, 3:56 pm

    Yep, the Roth IRA is pretty awesome! I definitely agree with your investment strategy of 401k up to the matching, and then Roth IRA after that!

    Also, I have a video that explains the Roth IRA that you might find helpful/entertaining.
    http://www.thousandaire.com/2010/10/03/what-is-a-roth-ira/

  • Everyday Tips November 24, 2010, 7:11 pm

    It’s funny, because some could say “I wish I could invest in a Roth IRA”. However, you could also consider yourself lucky if you can’t because you make too much money!

  • LifeAndMyFinances April 13, 2011, 3:54 am

    Great summary on the Roth IRA. I think they are a great investment tool to use once you max out your 401(k) contributions (assuming that you have a match at work). My wife and I currently have a Traditional IRA and a 401(k), but I think I just might open a Roth IRA soon too! $5,000 a year really isn’t that much in the grand scheme of things… that’s less than $500 a month!

  • Robert Muir April 13, 2011, 12:03 pm

    It’s questionable as to whether you would want to invest in international funds from a Roth. Keep in mind that international funds have to pay foreign taxes (that you could normally deduct from your income for federal tax purposes). Since the funds are in a Roth, you wouldn’t be able to deduct the foreign taxes and foreign entities do not recognize the “tax free” benefits of the Roth.

    Of course we’re not talking about a whole lot of money, but it is something to consider.

    • retirebyforty April 13, 2011, 8:14 pm

      You’re right about that. I forgot about the foreign tax credit. I’ll have to rethink my asset location strategy again.

  • First Gen American April 13, 2011, 1:21 pm

    I think I found a bit of a Roth IRA loophole for the high income earners. If you invest after tax money in your 401K and then roll it over to an IRA, it goes into a Roth account. I had to do this a few years back after my company was sold and had to move accounts and it was all kosher.

    • retirebyforty April 13, 2011, 8:16 pm

      Are you talking about Roth 401k? I invested in Roth 401k in 2010 and I am regretting it a bit because I could have saved a lot of money in tax. I think regular 401k is better for people in higher tax bracket because tax takes such a huge chuck out of the investment.

  • krantcents April 13, 2011, 2:03 pm

    Roth IRAs are good for a lot of things, you do not have to take a distribution like a regular IRA. Also, you can pass it on to your heirs.

  • Money Reasons April 13, 2011, 6:14 pm

    Nice chart too by the way!!!

    Using a Roth makes total sense, maybe not the complete picture but still very good 🙂

  • Justin @ MoneyIsTheRoot April 14, 2011, 10:53 am

    Thanks for the explanation. I have been giving more serious thought to starting a Roth IRA…I really just max out my 401k now, and then invest in an online brokerage. At some point in the future I will go over the income limit, so maybe it’s best I start doing it now?!?!

    • retirebyforty April 14, 2011, 10:37 pm

      Yes, you should contribute to the Roth IRA while you can. You’ll regret not doing it once you’re over the income limit. 🙂

  • retirebyforty April 15, 2011, 11:01 am

    Thanks for the idea. I’ll make sure to submit the post.

  • Dave April 15, 2011, 1:17 pm

    Another reason to fund a Roth for a child’s earnings is that it will not be counted against them as an asset when they fill out the FAFSA form for financial aid for college.

  • Spruce Up Your Finances April 18, 2011, 8:41 am

    Roth IRA is a great option especially if you have already maximized all your job retirement plans such as the 401(k), 403(b), 457, etc. It is a very good retirement option since the distributions or withdrawal are not taxed (subject to certain exceptions) and there is no time frame on when you can withdraw unlike all other retirement plans where it is mandatory to start withdrawing once you reach the age of 70 1/2 years.

  • AV July 9, 2011, 10:39 pm

    Hi. I am thinking to start a roth IRA but our joint income is 180,000. Me and my wife contribute to 401k at work but $2,000 a year each only. If we contribute more to 401k will that reduce our MAGI and make us eligible for roth contribution?

    • retirebyforty July 10, 2011, 2:40 pm

      If you contribute to the 401k plan, then your MAGI should go down enough so you can contribute to the Roth IRA. I believe the phase out begins at 169,000 so if you go below that you should be able to contribute the full $5,000. See the IRS Roth IRA page to make sure.
      Disclaimer: I am not a tax professional and you should consult a qualify professional for legal advice.

  • Kevin M July 28, 2011, 2:48 pm

    Another little known advantage of the Roth is that you can also do a spousal contribution/account, even if your spouse doesn’t have any earned income. As long as one spouse has enough earned income to cover both contributions, you’re good to go.

    That can be important because it virtually doubles the size of the contribution from $5000 to $10,000 ($12,000 if you and your spouse are 50 or older). The account(s) will grow a good bit faster with the doubling.

  • isabella September 10, 2011, 1:17 pm

    Just wondering about the Either IRA, I’m not too well informed. New to this. Is there a certain gross income limit to be able to contribute tou a ROTH IRA.

    • retirebyforty September 12, 2011, 9:55 am

      The income limit for Roth IRA – AGI is more than $179,000 (joint.) You can always invest in a regular stock account if your AGI is too high.

  • Scott @ RothIRA.org January 27, 2012, 11:36 am

    If you’re under the income requirements there really isn’t a reason not to start a roth ira. Some people should even be contributing more if possible and if they are really interested in managing their own financial opportunities they might even consider a self directed roth ira although there really only a handful of companies that are familiar with the specifics of these setups but make a lot of sense given the housing market.

  • Eric October 25, 2013, 6:28 am

    Big fan of Roths here. Have done some conversions as well, though I know that is perhaps a step too far for some. In an emergency, you can always get your contributions back out without tax or penalty (rethink the emergency fund?). After five years you can get conversions out as well. No minimum withdrawal rules. In retirement, take what you need, or not, and it won’t affect your tax bracket for everything else. No effect on social security taxability, deduction or exemption phaseouts. No effect on your tax rate on qualified dividends or long term cap gains. No effect on the passive loss rules (the 150,000 AGI threshold for deducting losses, etc.). No impact on threshholds relating to Affordable Care Act taxes. There’s more, I’m sure, but these just rattle off the top of my head.

  • Mayan Queen March 31, 2014, 3:09 pm

    I just made a mistake and need feedback! I rolled over an annuity from a sort of “ghost company”. It just had been sitting there and wanted to have a closer look so I talked to this guy that works for Primerica. He said he could roll it over with no problem. I ask what the fee will be, he said $20 year. I thought $20, not bad. I thought it is just a small account that has been sitting there and why not have this guy do it for me. To my surprise the annuity had been rolled ok but there was a charge of close to 5% based on the value of the account. I called the Primerica guy and he said “I will get back to you with the information for the charge”. He later said that it was a charge for the acquisition of the shares. I asked, “why didn’t you disclose that charge”, he just apologize. I continue, is there going to be a charge of 5% every time I contribute to the IRA? He said, “Yes”. What did I do wrong, besides going to a third party? I feel so stupid. Is this the usual charge? Any advice?

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