When life offers you a gift, you should graciously accept it. For example, when you wake up on a bluebird powder day with green light stability, you should race up to the mountains to slay some turns. Similarly, when the government offers you a gift, you should take it and run. Don’t ask questions and don’t waste time. In the quest for financial freedom, the greatest gift the government will ever give you is the Roth IRA. EVERYONE should be contributing to a Roth IRA, starting as young as possible and continuing for as long as possible.
What is a Roth IRA?
If you are just starting your journey to financial independence, you may not be aware of the differences in the various retirement accounts available to you. We won’t go into all the details of the different retirement accounts in this post. We are only talking about the KING of all retirement accounts, which is the Roth IRA.
With a Roth IRA, you contribute AFTER-tax dollars. Your Roth will then grow tax-free with no further taxes at any point in the future, even when you eventually withdraw the money later on in your life. It’s a pretty sweet deal. The government knows this and I wouldn’t be surprised if they change the rules at some point in the future. All the more reason to start contributing to a Roth ASAP!
How to Contribute to a Roth IRA
In order to contribute to a Roth IRA, you need to have earned income. Which means you need to have a job. If you do not work for a year, you can not contribute to a Roth in that year.
If you make less than $118,000 (single) or $186,000 (married filing jointly), you can contribute directly to a Roth IRA up to the $5500 per person / year limit. Just head over to Vanguard (or Fidelity or Charles Schwab, or any other discount brokerage firm), open up a Roth IRA, and then transfer money from your checking account into your Roth IRA.
If you make more than the limits above, you can still contribute up to the $5500 limit, but you need to take an extra step, called the Backdoor Roth.
The Backdoor Roth
If you are a high income earner, here’s how you can make a full contribution to your Roth IRA:
- Open up a Traditional IRA (make sure there is $0 in your traditional IRA when you start this process)
- Contribute $5500 (after tax dollars) to your Traditional IRA
- Park the money in your Traditional IRA in a money market account
- Once the money is available for transfer (Vanguard usually places a hold of around a week), transfer the money from your traditional IRA into your Roth IRA (Called a Roth Conversion)
There are some nuances to the Backdoor Roth IRA, which have been well discussed over at the White Coat Investor. Also, tax time can be a little complicated, but if you use TurboTax, you can follow the simple step-by-step instructions over at The Finance Buff.
The Power of a Roth
Let’s say you’re ahead of the game and you have the fortune of reading this blog when you are 22 years old, fresh out of college. You contribute $5500/year, each year for the next decade and then stop.
At the end of the decade (when you are only 32 years old), you will have $72,000 of tax-free money (assuming a reasonable 5% rate of return). If you just let it grow and don’t contribute any more money to your Roth, by the time you are 65, you will have $360,000. Not bad!
But why would you stop contributing at age 32? Even if you have a really chill part-time job, you should be able to find $5500 per year to contribute until you are 65. If you keep contributing $5500 per year starting at age 22 until the time you are 65, you will have nearly 1 million dollars. And this assumes no other savings. Remember, that 1 million is particularly valuable because it is not taxed EVER AGAIN. It’s your money, all of it.
If you are more of a late starter, and didn’t figure out about the Roth until your 30’s or 40’s, you won’t have the same benefit of compounding, but you will have the benefit of no more taxes (EVER) on that money. If you look at the historical income tax rates, you will see that we currently enjoy some of the lowest federal income tax rates in history. Therefore, it would be a good bet that tax rates are going to go up in the future. However, if you have a large proportion of your portfolio in a Roth IRA, you will essentially be unaffected by higher tax rates. After all, withdrawals from a Roth IRA are tax-free!
The Catch: Roth Space is Limited
Hopefully at this point you’re convinced of the benefits of a Roth IRA. As with anything good in life, there is a catch. For a Roth, the catch is that if you don’t contribute to a Roth in any given year, you lose that special tax-protected space forever. You want to maximize your tax-protected space, and that is why you should start contributing to a Roth IRA as early as possible. You can’t go back and contribute to prior years.
One of my biggest financial regrets up to this point is not contributing to a Roth IRA earlier in my life. The first year I contributed to a Roth IRA was when I was 33. Assuming I could have contributed to a Roth as early as 15 when I mowed lawns and spread bark, I have lost out on around 15 years of potential Roth space contributions, which would be several hundred thousand tax free dollars assuming several decades of compounding. If you are reading this in your 20’s, don’t make the same mistake!
Summary
The Roth IRA, the KING of all retirement accounts, is a wonderful gift from the government. Don’t turn it down and don’t wait to contribute. If you didn’t start it in your 20’s, start NOW and keep contributing for as long as possible. It’s your only way to amass tax-free financial freedom, and it may not be around forever. Use it or lose it!
What do you think? How early did you start investing in a Roth IRA? Do you think the Roth IRA is better than tax-deferred retirement accounts like the 401k?
I’m aaaall about that Roth, baby. I honestly didn’t understand retirement accounts very well when I set it up, but I’m very glad I have a Roth today. We’re just below the filing jointly income threshold, so I’m hoping we can continue to contribute for a little longer.
Remember, even if you go above the married filing jointly threshold, you can still contribute to two Roth accounts via the “Backdoor”.
Nice review of the Roth IRA, LFMD. For attendings, I would prioritize the traditional 401k because your tax deduction rate when you contribute is more than the tax rate you save in retirement.
Hi Wall Street Physician. Thank you for your comment. I can appreciate that reasoning, especially for high income earners. However, if tax rates increase significantly over the next several decades, the tax savings from a Roth in retirement could theoretically surpass the current tax savings from contributing to a Traditional 401k. Thankfully, most attendings should not have to make the decision between a Roth and a Traditional 401k. They should be maxing out BOTH accounts without blinking an eye.
Thanks for this information, LFMD. I never heard of the Backdoor Roth IRA, so that was particularly interesting to me. I have a TSP account with my government job, but haven’t contributed to a Roth. Might be something to discuss with my wife as we are both in our early 30s. Thanks for sharing!
Dave
You’re very welcome Dave. Definitely look into the Roth. When you are in retirement, you will appreciate having both tax-free (Roth) and tax-deferred (TSP, or 401k) income.
Thanks for the great article, I just stumbled upon your site after reading a post on WCI. My wife and I have around have a bunch of $ in traditional IRA’s due to 401k rollovers from previous jobs. Everything we roll over from there to a Roth would basically be taxed as income for that year right? Do you have any tips on standard roll overs?
Thanks, Tippy
Hi Tippy. If your IRA consists of rollover money from your prior 401k’s, then none of this money has been taxed yet. If you “convert” (this is the proper term, not roll over) everything from your IRA to a Roth IRA, the entire amount will be added to your income and taxed at ordinary income rates.
Generally, you only want to convert your IRA money to a Roth IRA when your earned income is low (perhaps in the early years of retirement), so you will be in a low tax bracket.
If you want to do a backdoor Roth each year, you will need to get rid of the money in your IRA to avoid the “pro-rata” rule. You may be able to transfer the IRA money into your current employer’s 401k (this depends on the plan). Or, if you have self-employment income, you can rollover your IRA money into a solo 401k.
I hope this is helpful. Please let me know if you have any additional questions.
Great article. I wanted to get your advice and the advice of others. I’m 40 and have been in practice for 10 years. My wife worked until we started having kids, and now is a stay-at-home Mom. I contribute the max to my 401K every year (and utilize a safe harbor match). I have my own IRA, my wife has an IRA, and we have a JTTEN IRA. I have never contributed to a Roth.
Here’s my question. . .is it still worth opening up a new IRA so I can start contributing $5,500/year through a backdoor Roth IRA? I vaguely remember discussing the Roth with a financial advisor when I first got out of residency and he basically said, “you and your wife make too much money, you don’t qualify” and that was it. I’m enjoying your blog – congrats on defeating the debt monster. I’m a long way from taming the beast, but I’m trying. . .
You can do a backdoor Roth (regardless of income) but you need to be careful about the “Pro-Rata” rule.
Basically, you must have a balance of zero in your traditional IRA(s) at the time when you begin the Backdoor Roth Process. Otherwise, you will owe additional taxes on the conversion. One way to get your traditional IRA accounts to zero is by rolling them into your 401k.
The backdoor Roth Process can get VERY complicated if you already have a Traditional IRA, so I recommend you arm yourself with some knowledge. The two articles below are a good starting point:
1. This article explains the consequences regarding the pro-rata rule: http://news.morningstar.com/articlenet/article.aspx?id=364861
2. This article explains how to perform a backdoor Roth in detail, and how to avoid the pro-rata rule: http://whitecoatinvestor.com/backdoor-roth-ira-tutorial/
I hope this helps. Please let me know if you have any additional questions.
If Roth beats out a traditional IRA – what if your company offers both traditional and Roth 401ks? Is a Roth still better because it is already taxed and will be all your money the same as you say for the IRA or is the possible tax break now better if it will move you down a bracket using the traditional 401k?
If you have filled up your Roth IRA and your employer offers a Roth 401k, I recommend the following general rule: If you are in a very high tax bracket (i.e. you make > $200K per year), then do the traditional 401k. If you are in a lower tax bracket (make < 100K per year), then do the Roth 401k. If you are in the middle, then you can spit the difference and put 50% in Roth 401k and 50% in the Traditional 401k. Some of this is a personal choice, and there isn't one perfect answer. However, I doubt anyone complains of having too much Roth (tax-free) money when they get to retirement...