3 Good Reasons to Open a Roth IRA
There’s no hiding the fact that the financial system is a jungle, complete with quicksand, predators, and those who just want to chop it all down. Negotiating the terrain can be difficult even for those with experience, and it is easy for anybody to get lost. Every day we hear stories about people disappearing or re-emerging: families that have been foreclosed on or those finally paying off a student loan.
Like it or not, most of us have to interface with the financial system, and we have to understand it in order to plan effectively for the future. The financial system services our regular banking needs, it finances our home and auto purchases, and perhaps above all it supports our retirement system, shoddy though it may be.
Fortunately, retirement accounts like a traditional or Roth Individual Retirement Arrangements (Roth IRAs) are pretty straightforward. These accounts are designed to encourage people to invest in their own retirement by incentivizing saving. Traditional IRAs allow people to take a tax deduction for putting money away, allowing them to simultaneously save for retirement and lower their tax liability. In the business, we call that a win-win. Investments in a traditional IRA grow tax deferred and are taxed only when they are withdrawn.
Roth IRAs are a little more involved. They flip the tax mechanic around, meaning you pay taxes on the contributions you make, but withdrawals are not taxed. If you don’t have a Roth IRA, here are a couple of reasons why you might want to look into one.
1. Recent retirees
Just because you’ve retired doesn’t mean you have to stop saving for retirement. The cutoff age for contributions to a traditional IRA is 70.5 years, but there is no age limit for a Roth IRA. However, income stipulations still apply. You have to have earned some income during the year in order to contribute, even though you’re contributing after-tax income to begin with, and income from investments and pensions doesn’t count. This applies if you retired in the middle of the year, for example, or you picked up freelance gig for old time’s sake and didn’t immediately blow the money on a vacation to Mexico.
If you aren’t earning any income but your spouse is, they can make contributions to your retirement account on your behalf — and keep in mind that if you’re over the age of 50, you qualify for catch-up contributions. For 2015, the standard contribution limit is $5,500 and the catch-up limit is $6,500.
Every retirement savings calculator on the planet will tell you the same thing: It is, quite literally, never to early to start saving for retirement. This is a lesson that compounding interest and hard economic times drives home — the earlier you save, the better. (If you want to remind yourself of the power of compounding interest, Investor.gov has a simple calculator that can be used for demonstrative purposes.)
It may sound a bit extreme, but if you have kids who are still dependents (or if you are someone’s dependent), it may be worth encouraging them to open an IRA — specifically, a Roth IRA, unless they are making more than $6,100 per year. Here’s why: Not only will investments in the account take advantage of the power of compounding interest over long periods of time (think 50 years to retirement from age 18), but the money will grow tax free. Contributing to a Roth IRA as a dependent with less than $6,100 in income is particularly clever because you are probably in a 0% income tax bracket, meaning you can’t take advantage of the deductions offered by the traditional IRA but can full well take advantage of tax-free growth and withdrawal down the line, when you will likely be in a higher tax bracket.
Parents who are fortunate enough to find themselves with both children and extra cash can also open custodial IRAs for young children. These accounts are not only a great gift (really, much better than another video game), but they also serve as a valuable educational tool.
If you’re a freelancer, odds are you have taken a few crash courses in finance. Financial activities like filing taxes or saving for retirement can be particularly nightmarish for freelancers, and having to go through the motions is a sort of higher education in and of itself.
Partially because of this, odds are also that you are woefully under prepared for retirement. Freelancers generally don’t have access to employer-sponsored retirement programs like 401ks or, less common, a pension. Freelancers also have a more variable income stream and more erratic expenses because they finance their own business activities.
The good news is that a Roth IRA should be palatable for most freelancers. First, you make contributions with after-tax earnings, so you don’t need to worry so much about managing contributions from sources of income. This allows you a little more flexibility in when and how much you contribute to the account.
Second, withdrawals from a Roth IRA are tax free, and you do not incur a penalty on withdrawing contributions (in a traditional IRA, you incur a 10% penalty if you withdraw money before retirement). If the shit hits the fan, you can lean on your Roth IRA for some support. Just keep in mind that you can’t withdraw any earnings generated within the account without penalty, just contributions that you have made.
Third, you can max out your IRA contributions as a freelancer if you earn as much as the maximum contribution, which is $5,500 in 2015 ($6,500 catch-up rate). Also keep in mind that if you’ve had a rough year, you don’t have to contribute to an IRA.