This post continues my thoughts on the best ways to put your money to work. In the first post I introduced my investing pyramid strategy, and talked about the 401k which serves as the base and first location for my investible dollars. The next place I like to invest my money to work for me, and the next level of the investing pyramid, is the IRA/Roth IRA.
IRA/ Roth IRA
IRA stands for Individual Retirement Account. An IRA functions similarly to a 401k, where you can put money into an IRA and it grows without the hindrances of taxes on any appreciation or dividends. The “normal” IRA is pre-tax meaning you can deduct the amount of money you put in it from your income that year, and you only have to pay taxes on the money when you withdraw it. The Roth version is after tax, which means you don’t get to deduct your contributions from your income, but you do get to withdraw the money without paying any additional taxes on it.
One thing with an IRA is that you must have employment compensation i.e. income from a job in order to contribute, so if you or your spouse does not work you are unable to contribute (bummer for stay at home spouses). But because of some of the quirks of the IRA and Roth IRA they are a great tool to use when planning for financial independence and early retirement.
Another thing to note with the “normal” IRA is that there are income limits that kick in and remove the tax deduction if you make over a certain amount in a year. If this is the case for you, you’ll want to contribute to the Roth IRA instead, that way you don’t pay taxes on it twice.*
So for 2015 if you are married, and you and your spouse make more than $118,000 you can still contribute to an IRA, but you lose the ability to deduct that amount from your taxes. But the Roth IRA is a pretty sweet consolation prize. Especially for those of us aiming for FI and early retirement.
The super-de-duper Roth IRA
The reason the Roth IRA is so sweet for the FIRE** crowd is because you don’t have to wait until you’re in your 60s to start withdrawing from it. The Roth was initially intended as a starter retirement account for people that aren’t sure they can afford to put away money for retirement. What this means is that you can withdraw all of the money that you’ve contributed to the Roth, except for any of the appreciation. Here’s an example.
Let’s say you’ve decided to start saving for retirement and you think the Roth IRA is the way to go. You contributed $5,000 for the last three years, $15,000 in total. But because the market has been on a tear lately, that original $15,000 has grown to $18,329, giving you a gain of $3,329 over that time. Say you want to start a business or need some money for a down payment on a house.*** Since it is a Roth IRA you can withdraw the $15,000 you put in, but the $3,329 gain has to stay in the account until you hit 59 1/2 just like a traditional IRA.
This early withdrawal without any penalties makes the Roth IRA a great option for those of us who are lucky to retire early. Using the Roth IRA you can grow your investments tax free and then withdraw your contributions to fund your early retirement until you reach 59 1/2 and can take normal distributions.
I’m gonna help you save some money!
Quick Tangent – I didn’t know where the name Roth came from so before writing this I decided to look it up. The Roth IRA was made possible as part of the Tax Relief Act of 1997, and is named after the bill’s sponsor William V Roth Jr. a Senator from Delaware.
Another technique that you can use in early retirement is to convert portions of your normal IRA into Roth IRA when you are in early retirement and are probably in a lower tax bracket than during your working years. The Mad FIentist has a few great posts on IRAs and this process that he calls IRA laddering. So hop over there to take a look if you are interested.
With all of the benefits of the IRA/Roth IRA the reason that it ends up second in priority is because of the contribution limits. For 2015 the maximum you can contribute is $5,500 or $6,500 if you are over 50. The Roth IRA is great, but you’ll need to sock away more than $5,500/year if you want to hit FI well before most people.
Well that wraps up the second layer of the pyramid. If you have any questions or comments on how you invest differently please let me know.
*Confession from Frugal Buckeye – This is another reason why it is good to understand these types of things and track your income/spending. I had an automatic withdrawal set up for my IRA and the next year when I received a raise at work that bumped me over the IRA deduction limit I forgot to change it to deposit into a Roth until after a few deposits had already been made. Not a huge mistake, but still something that could have been avoided with some planning.
** Financial Independence Early Retirement – not firefighters, although I suppose it’s still an awesome option for them too.
*** Note, not that raiding your retirement is always a good idea for either one of these plans, but this is just an example.