The Incredible Tax-Free Retirement Hack You've Been Missing: Roth IRA Explained

Welcome back to We're Talking Money. I'm Dustin Hocken, wealth advisor here at OmniStar Financial Group. I was chatting with a friend last night and he gave me the inspiration for this episode. Now this friend, I would consider him one of the most intelligent people that I know. We were talking about his financial planning and talking about different savings and investing, and we started talking about a Roth IRA.

He has done a lot of homework and he knows a lot about the Roth IRA. He knew most of the points that we brought up, but there were a few things that we were talking about that he wasn't aware of. This made me realize that there's probably one or two things that most people don't know about a Roth IRA. That's why I'm filming this episode. I'm going to give you all the information you need to know about a Roth IRA right now. Stay tuned.

So, Roth IRA: what is it? A Roth IRA is a qualified retirement account. Now this account has all the tools to be one of your favorite accounts in retirement, and that's because any money that you put in grows 100 tax-free and can be distributed 100 tax-free after the age of 59 and a half.

So why Roth IRA? Now if you're not sure if a Roth IRA is right for you, this account can make all the difference. Let's look at the math. Let's walk through a couple examples of two retirees: one with only IRA or 401K money, all taxable, and option number two, Roth IRA in the mix.

Now let's say that we need ten thousand dollars a month after taxes in retirement. What's going to make up our 10 grand? So first, Social Security, some guaranteed income. Now let's assume that between two spouses reading three thousand dollars a month of Social Security income. Now we need to find out where the extra seven thousand dollars and what is coming from.

If we only have IRA or taxable money, we're going to pull out ten thousand dollars a month roughly to get to your seven thousand dollars after tax. That means we're paying 3000 dollars a month in tax, or over the course of 12 months, thirty six thousand dollars in taxes.

Now for couple number two, let's say that we have a Roth IRA that we help supplement their retirement, and let's just assume that we can pull out three thousand dollars of tax-free money out of the Roth IRA. That means we need to find four thousand dollars to bridge our ten thousand dollar account. Well, if we need four thousand dollars after taxes, that means we need to take out a little bit less than six thousand dollars a month to get that four. So that's a little less than two thousand dollars a month of tax.

That means instead of paying thirty six thousand dollars a year in tax in our first example, you're gonna be paying less than twenty four thousand dollars in tax. That's twelve thousand dollars of savings of tax per year. That's a massive difference. Trust me, if it hurts to pay taxes now, wait until you're in retirement and you're paying tax out of your investments.

So now that we know Roth IRA is a powerful tool, who can contribute and how much? There's a great rule about a Roth IRA: anyone with earned income can contribute. That's right, anyone. So let's assume that you're a business owner and you have a four or a five year old. Well, you could pay them six thousand dollars a year and actually transfer that six thousand dollars from their salary into a Roth IRA. That means they could have a Roth IRA starting at age five, and they'll have 60 years of compounding interest. Talk about power.

If you're a stay-at-home spouse and your wife makes all the income, that's another great rule. You can actually use your spouse's income to contribute to a Roth IRA.

With all great things, there are going to be some limits. There's both contribution limits and income limits. The contribution limit in 2023 goes up to 6 500, with a thousand dollar catch-up if you're over age 50. That means if you're over 50, you can contribute 7 500 into the Roth. The modified adjusted income limits for the Roth IRA in 2023 is 153 000 for single taxpayers and 218 000 for married filing jointly.

Cash, that really stinks if you make too much money and you can't contribute to a Roth IRA, right? Wrong. There's a loophole in the tax code that allows us to do what's called a backdoor Roth IRA. Some of you may know this, but here's how it works. So we take that six thousand dollars that we're gonna contribute into the Roth IRA, but we can't because we make too much money, and we're gonna put that money into a traditional IRA. That money is going to sit in the traditional IRA. Once it settles, we're going to convert the traditional IRA into the Roth IRA. There's no income limits on converted assets in the tax code, so that means we can pump that in, not take a deduction, and now all of a sudden convert it over no matter how much money we make. Very powerful.

Another very powerful trait of the Roth IRAs: there's no requirement of distributions at age 72. RMDs are required minimum distributions, our distribution that you're forced to take out of your 401k and IRA at age 72 because the government wants you to pay their taxes. Well, with the Roth IRA there are no taxes, there is no requirement of distribution.

Now if you inherit a Roth IRA not from your spouse, then you have 10 years to pull the money out. But remember, all those distributions also come out tax-free. That's right, even inherited money out of a Roth IRA, 100 tax-free.

Now let's talk about some distribution rules. So this is really where the IRA can make a lot of difference, not only for retirement but pre-retirement. It can be a great mid to long term tool. That's because any money that you put into the Roth IRA, your contribution, you can pull out at any point in time for any reason, tax-free, penalty free. This is just a return of contribution. This doesn't include the earnings. We'll need some special exemptions for that, but I'll dive into that and more on episode two of Roth IRAs Explained.

Having access to your contributions tax-free, penalty free can be extremely powerful. Think about this: if you have a child and you start maxing out your Roth IRA, let's just assume six thousand dollars per year with no inflation, which we know the contribution limits are going to go up as they always do. Let's just assume we do 6 000 every year for 18 years, so it's over a hundred thousand dollars that you can now use tax-free, penalty free for your child's education. And what's even cooler, that a lot of people don't know, is that this isn't counted on your child's FAFSA because it's your retirement account.

This distribution doesn't include converted assets. So for the backdoor Roth IRA, if you convert money into a Roth IRA, you can't immediately pull it out. You have to wait five years. You don't wait five years, then you're assessed a ten percent penalty.

When a distribution occurs in a Roth IRA, you get the best to the worst. Here's how it works. You get your contributions out first: no taxes, no 10 penalty. Converted assets come out second: no taxes, but a 10 penalty. And earnings will come out third: taxes and a 10 penalty. Pretty good order if you're taking money out.

So I hope that first part of the Roth IRA video has been helpful. We've got more information to dig into, and we're actually going to be a little bit more complex with video number two. Make sure you like, share, subscribe to our channel so you can see part two of the Roth IRA. Definitely information that you want to know if you have this encounter, if you're considering a Roth IRA, and we'll talk to you soon.

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