Ep #30: Building Tax-Free Wealth Using the Roth IRA

Introduction

"Alright, today we are continuing our discussion on retirement plans and ways to save, invest, and build wealth outside of our business. Remember for many owners out there it is highly likely 80% of your wealth is your business. So the past two episodes I discussed different retirement plan options like the 401k and the SEP IRA, the Roth IRA is something you can do in addition to those plans if you wanted to. You can put up to $6,500 into a Roth IRA per year and if over age 50 an additional $1,000 if your modified adjusted gross income is under the phaseout limits which I will get into later in this episode. Now I realize with the Roth you cannot put in nearly as much on an annual basis compared to the 401k or SEP IRA."

The benefits of the Roth IRA

"However, for business owners who are making $300,000- $400,000 a year, maxing out your SEP or 401k, using the Roth as an additional savings vehicle could be a good strategy for you.

So first one of the biggest differences I want to mention right away and make sure everyone understands before we dive into the benefits of the Roth IRA is that when you put money into a Roth IRA, it is with after-tax dollars. Meaning you are paying taxes on that money when it goes into the Roth IRA. There is no upfront tax deduction but when you take money out down the road it is all tax-free. I will come back to this shortly so let’s start running through some of the benefits."

Tax-Free Growth on Your Money Invested in a Roth IRA

"You don’t have to worry about reporting any earnings that you made on your money. This includes any interest or dividends that you may receive within the Roth IRA depending on what investments you own."

Tax-Free Withdrawals in Retirement from your Roth IRA

"Second, you can take tax-free withdrawals in retirement if you meet certain rules. So if you’re age 59.5 or older and you have owned your Roth IRA for at least 5 years, you can withdraw your contributions and earnings – from your Roth IRA without paying any penalties or taxes. One thing I want to mention and clarify in regards to the second part of this rule which is owning the Roth IRA for 5 years. I receive a lot of questions on "when does the clock actually start to satisfy the 5 years." It does not start if you just open your Roth IRA. You need to open the Roth IRA and fund it. The five-year period starts on the first day of the tax year for which you made a contribution to your Roth IRA. This includes if you started funding your IRA with a prior year contribution. So as an example, if you contribute to a Roth IRA for the first time in early 2023 before the tax deadline of April 18th, and you make the contribution for 2022 tax year, then the five years will end on Jan 1, 2027.  5 years after Jan 1, 2022."

"So if you are over the age of 59.5, don’t just assume all of your earnings are tax-free, make sure you also qualify for the 5-year holding period."

There is No Required Minimum Distribution in a Roth IRA

"There is an IRS rule that states when you turn age 73, you must take money out of your Traditional IRA, SEP IRA, SIMPLE IRA, and retirement plan accounts. If you don’t take that money out, there is a 50% penalty. This does not exist with Roth IRAs."

The "Backdoor Roth IRA" Conversion

"Another benefit for those who make too much money and are above the income limits, is you may be eligible for a “backdoor Roth IRA conversion”. There is a phaseout to contribute to the Roth IRA. Meaning if you file Single for tax purposes and your income is more than $153,000, you don’t qualify to contribute to a Roth IRA. Or if you file MFJ and your income is above $228,000, you don’t qualify as well because you’re over the phaseout limit. The backdoor Roth is a simple way to get around that. You would make a non-tax deductible contribution to a traditional IRA – which has no income phaseout limits then you’d move that money from the Traditional IRA into a Roth IRA using a conversion. Yes, this is a legal strategy, the IRS is aware of it so you can totally do it. I would recommend getting tax advice first because this will be a taxable event and it can get messy if you also have existing traditional IRAs. So please this is not a recommendation to do it on your own, reach out and get some help, but it can definitely be done for those folks who are over the phase-out limits."

The Beneficiaries of Your Roth IRA Won't be Taxed

"So if you own a Roth IRA and you pass away, the beneficiaries listed on your account will most likely have to open a Roth Beneficiary IRA account in their name. And they receive their percentage of your account at whatever amount you had them listed as. As of right now, for 2023 the Roth IRA beneficiaries will have to take required minimum annual distributions but they won’t have to pay any federal income tax on their withdrawals as long as you had your Roth IRA in existence for 5 years. Now what will be changing starting in 2024, Inherited Roth IRA accounts will no longer be required to take any required minimum distributions. So the Roth gets even more attractive not only for yourself while you’re living but as an account to be part of your estate plan and pass down assets to your kids and family. They can inherit your Roth IRA, not be forced to take any money out and use it for whatever they want tax-free. That’s a pretty good deal if leaving a legacy is important to you."

Tax-Free Access to Your Roth IRA Contributions

"The last benefit I will mention is the flexibility a Roth IRA can provide if you need access to your contributions. Any money you put into the Roth IRA (so your total contribution amount) you can take out penalty-free and tax-free whenever you want. As an example, If you’ve had a Roth IRA for 3 years and its value is 30,000. Let’s say of that $30,000, $20,000 are the contributions that you’ve made into the account. And the remaining $10,000 is the earnings and growth you’ve made over the 3 years. At any time you have access to take out that $20,000 penalty-free and tax-free. If you took out more than 20,000 you are dipping into the earnings which could be subject to a penalty and taxes if you’re under 59.5 and you haven’t had the Roth IRA for at least 5 years."

"So in summary, the Roth IRA can be a fantastic savings vehicle in addition to contributing to a 401k or SEP IRA. You just need to have earned income in order to make a contribution to the Roth IRA. I will include resources in the show notes for those who’d like to look into the details and you all make it a great day."