Roth IRA 101

This is a post about a Roth IRA 101. Let’s look at the basics of a Roth IRA and more importantly, how we can increase income through a Roth IRA investing. None of this is original. I went scouring through the internet to piece these together. So if you want to do your own research, please go ahead. If you find something interesting, then please feel free to drop in the comments and share with the community.

What is an IRA?

First, the IRA stands for Individual Retirement Account.  And according to Investopedia, “…it is a long-term focused account that individuals with earned income can use to save for the future while enjoying certain tax advantages.”

It is basically a tax-advantaged retirement account to which you contribute either pre- or after- tax. Whatever amount you contribute grows in the account either on a tax-deferred basis or on a tax-free basis.

Money held in an IRA usually can’t be withdrawn before age 59½ without incurring a hefty penalty of 10% of the amount withdrawn. There are annual income limitations that apply to traditional IRAs and Roth IRAs.

There are 4 types of IRA accounts:

1. Traditional IRAs,
2. Roth IRAs,
3. Simplified Employee Pension (SEP) IRAs, and
4. Savings Incentive Match Plan for Employees (SIMPLE) IRAs

To keep things simple, I am not going to delve into the last two types: SEP and SIMPLE.  This is because these last two IRAs are for your employers (unless you are a business owner).  So, since I am a regular 9-to-5 guy (individual tax payer), I will look at the first two only.  

Note – in case you are curious, you can click the links to take a look at the SEP and SIMPLE IRAs.

Traditional IRA vs. Roth IRA

So, if you are wondering what is the difference between Traditional and Roth, here is a quick glance at the difference between the two IRAs.

	Traditional IRA	Roth IRA
Contribution limits	$7,000 (8,000 if you are 50 and older)	$7,000 (8,000 if age 50 or older)
Tax deduction – when contributing	Yes – Tax deductible (so your taxable income reduces by the amount that you put into your IRA account).	No – no tax deduction, you put your money into the Roth IRA after tax is already taken from your income
Tax deduction when withdrawing (distribution)	No – you are fully taxed when you withdraw your money	Yes – Distributions are tax free.  Whatever you have at the end, you take out tax free.
RMD (Required Minimum Distributions) – these are withdrawals that you must take after you reach a certain age) like 73 years old.	Yes – you need to start withdrawing money when you reach 73 years old	No – no mandatory withdrawing required.
Eligibility	Any individual taxpayers/couples	Any individual taxpayers/couples – but subject to MAGI (modified adjusted gross income) limitations – under $161,000 for single filing and $228,000 for joint filing. Basically, if you make more than 161k or 228 (for joint filing) you are not able to contribute to Roth IRA. But, even if you are over the MAGI limit, there is a backdoor Roth IRA that you can take advantage of.

Based on the simple comparison, most people would prefer the Roth IRA because you would think that the money you take out later when you are over 59 years old would be greater than the money you are putting in now. So, assuming that your income is smaller than the MAGI limit (or assuming you will take advantage of the backdoor Roth IRA scheme) it makes more sense to pay the tax now (since your tax bill would be smaller). At least this is how I am thinking.

Real Estate Investing vs. Roth IRA

Another question I had was the comparison between putting your money into Roth IRA vs. the Real Estate. Of course, it would be ideal to do both, but if you were on a tight budget, which is a better investment for your retirement?

	Real Estate	Roth IRA
Tax deduction	Mortgage interest, property tax, some maintenance expenses.	Tax deducted on the capital gains and when you withdraw.
Inflation hedge	Yes	Yes
Liquidity	Less liquid	More Liquid
Maintenance requirements (operational cost)	High	Low
Maintenance requirements (operational time)	High	Low
Transaction cost	High	Low
Home equity (ability to leverage funds)	Yes	No

Comparing the two, for someone who is on a budget and does not have much time to spare, it makes more sense to go with a Roth IRA. Real Estate is definitely a high maintenance investment and will require a higher upfront cost. So, for me, it’s pretty clear – Roth IRA is my investment choice. But, you might be in a different situation so, if you have different views, it’s all good. I hope to be able to get into real estate sometime in the near future.

What if you are making more than 146,000?

Backdoor Roth IRA is a technique used by high-income earners who exceed the Roth IRA income limit eligibility. You are basically paying taxes and converting a portion or all of your traditional IRA into a Roth IRA. By doing this, you are now free to grow your funds in the Roth IRA and not worry about paying taxes (capital growth or income) when you withdraw.

There are three ways you can create a Backdoor Roth IRA:

1. Contribute money to an existing traditional IRA and then roll over the funds to a Roth IRA. Or you can roll over existing traditional IRA money into a Roth—as much as you want at one time, even if it’s more than the annual contribution limit.
2. Convert your entire traditional IRA to a Roth IRA.
3. If your company 401(k) plan allows conversions, you can roll your 401(k) account over to a Roth IRA.

Tax Implications include:

• When you convert funds from a traditional IRA to a Roth IRA, you need to pay taxes on those funds.
• You will also owe taxes on the capital gains of those funds that were invested in your traditional IRA
• The funds that you put into the Roth IRA are converted funds not contributions. So, even though it is sitting in a Roth IRA, you need to wait five years for penalty free access if you are under age 59 and ½.

Conclusion

Roth IRA is a good idea and has many benefits (like not having RMDs).  The key benefit is that you pay taxes up front but everything after that is tax free.  However, not everyone is eligible (if you are a high income earner).  But, using the Backdoor Roth IRA scheme, even the high income earners can take advantage of it.