When it comes to reviewing retirement plan options it is clear that the Roth IRA rules the landscape. Owning a Roth IRA was the first recommendation I made to my two sons in their 20s. It is one of the smartest moves young investors can make and setting up a Roth IRA is easy. As we all begin to file 2013 income taxes, now is the time to identify what options may still be available for last year as well as to see how to increase the odds of having sufficient funds when money might be needed sometime in the future.
Retirement accounts typically enjoy tax-deferred growth. It is, however, when investors want or need to take out money that everyone screams over the income tax that is paid on every dime that is withdrawn. In the event such withdrawals take place prior to age 59 ½ there is an additional 10% penalty on top of federal and state income tax.
There are a few simple rules to follow to enjoy retirement savings accounts that grow absolutely free of any income tax. Unlike other retirement accounts and investment vehicles, investors will not owe any tax when withdrawals are taken from your Roth IRA. In addition, as noted by Kiplinger's Kevin Mc Cormally recently, IRAs are more flexible than 401(k) accounts in that you can invest in more than just cash, bonds, and stock funds to own real estate and alternative investment vehicles.
You have time until your tax return deadline to set up and fund contributions for 2013. The federal government limits 2013 and 2014 contributions to $5,500 for those under age 50. For those over 50 the limit is $6,500. So if you act before April 15, 2014 you can invest up to $5,500 as your previous year contribution. While you do have up until next year's tax filing deadline to contribute your 2014 funds, the earlier you place funds in your individual tax shelter, you can enjoy tax free earnings even sooner.
One of my sons said he wanted to wait until he could save $1,000 a month. I pointed out there's no time like the present to get started. In fact, when a 25 year old contributes $5,000 every year and earns 8% annually on the investment, by the time the investor reaches age 65 there will be about $1.4 million set aside at that time. But wait, there's more! When the investor waits until retirement age to start taking money out, there is zero income tax due. To put things further into perspective, by setting the withdrawal governor at 4% annually, the tax free income on $1.4 million is $56,000 a year. Now my son pointed out $56,000 won't buy then what it buys now. To which I countered with a question, what will not having money buy?
If there is $5,000 invested by a 25 year old in a taxable account for 40 years with the identical 8% annual return, the account value rests at approximately $1 million with federal taxes alone at 15% a year. Keeping our withdrawal limit at 4% means the income is now $40,000 or $16,000 less annually. State income taxes would make the account balance even less. Now we can see why some investors consider tax free investing to be the 8th wonder of the world.
Roth IRA account holders can always take out contributions income tax and penalty free for any reason. Also, if there are funds needed for a first time home purchase, in addition to taking contributions for the down payment the account holder can withdraw up to $10,000 of earnings income tax and penalty free if the account has been open for at least 5 years.
I am fond of saying, ask better questions to get better answers. Take the time to ask financial planners who are well acquainted with Roth IRAs to explain the benefits and the drawbacks. There are rules, for example, about income from a job must be the source of contributions, the limit on contributions has a ceiling below $114,000 single and $181,000 married filing jointly, how a Roth may be a great way to finance college education, and the investment options. It may be that a Roth IRA can be started with as little as $1,000 and it is easy to set up bank account drafts at $50 a month. Using time to your advantage isn't about getting rich. It's all about becoming wealthy, which is more valuable and sustainable over a lifetime.
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This information contained in this newsletter is general in nature and should not be construed as comprehensive financial, tax, or legal advice and the opinions expressed are not endorsed by NPC. As with any financial or legal matter, consult your qualified securities, tax, or legal representative before taking action.
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