I have mentioned Roth a few times in previous blog posts, and I thought it would be a good idea to break out what Roth really means and the different investment vehicles you can use to get ahead financially and secure your financial future.
The Roth 401(k) is the ability (as previous mentioned in prior blog posts) to put in after tax dollars in your 401(k) retirement account.
Why is this advantageous?
Assuming you will be making more money in the future, if you could pay lower taxes now, than in the future, would you take advantage of this opportunity?
The Roth 401(k) is one of my favorite retirement vehicles! All contributions you make are taxed initially but grow tax free. Let me repeat – your contributions will grow tax free! Yes, this is real. If you pay the taxes now, you never have to pay the taxes ever again! Let’s say it for those in the back who couldn’t hear: TAX FREE!
Check out these examples – Remember this is all Tax FREE:
Examples of Roth 401k Growth:
Please note this is purely an illustrative example and not investment advice.
Monthly Jack is saving $500/month or $6,000 per year
At a 7% annualized growth rate, in 10 years, Jack will have $82,898.69 ($60,000 contributions, $22,898.69 in interest/appreciation).
At a 7% annualized growth rate, in 20 years, Jack will have $245,972.95 ($120,000 contributions, $125,972.95 in interest/appreciation).
At a 7% annualized growth rate, in 30 years, Jack will have $566,764.72 ($180,000 contributions, $386,764.72 in interest/appreciation).
All the growth and appreciation in the Roth 401(k) per the examples after 10, 20, and 30 years is all yours. Zero will be paid in taxes when you retire. This is one of the biggest opportunities of wealth creation and changing your financial future.
How much can I contribute? What if I don’t get a 401(k) at work?
If your retirement plan at work does not offer a 401(k) or Roth 401(k), I would recommend maximizing your Roth IRA each year. The IRS maximum still applies to the Roth 401(k), just like the normal 401(k) – $19,500 (per 2021 IRS tax code). While you might have to pay more taxes today, you cannot miss out on this tax free compounding. If you have the option and can financially, I would also try to max out your Roth IRA of $6,000 (per 2021 IRS tax code). In total, you would be able to contribute $25,500 in Roth contributions.
Check out this investment calculator to see how much you could have in retirement of tax free money: https://www.calculator.net/investment-calculator.html
If you have earned any income, you should maximize your Roth 401(k) and Roth IRA. You cannot afford to miss out on this tax free growth!
Can I tell you a secret?
Even kids can have a Roth IRA! Imagine being a kid and investing into an account where your money can compound and growth tax free for 30, 40 or even 50 years! You would have hundreds of thousands, if not millions of dollars!
How can kids contribute to a Roth IRA?
- Anyone with earned income can contribute to a Roth IRA
- If the child is under 18, you will need to open a Custodial Roth IRA (aka the parent/guardian)
For example, say your child earned $4,000 while being a lifeguard, either the child or you, as the parent could contribute into their Roth IRA the full $4,000 (earned income). The child will still be capped at the IRS maximum of $6,000 (this amount is applies so long as one is under 50 years old), but this is a great opportunity for children to get started investing and letting the money growth tax free.
Additionally, parents can contribute the full amount, so long as the child has earned that amount. If Joey made $6,000 in 2021, you as Joey’s parent could contribute $6,000 of your own money into their Custodial Roth IRA. BOOOOM! That is one secret you should keep to yourself! Imagine your kid having millions just because you helped them start investing at a young age! I know some parents who will match what their kid puts into their Custodial Roth Account and it’s a great way to give your kids a financial advantage! This is a great way to incentivize your kids to invest and see the power of compound interest!
Example of Custodial Roth IRA Growth:
Please note this is purely an illustrative example and not investment advice.
Monthly, little Joey is saving to hit $6,000 per year, from being a lifeguard during the summer
At a 7% annualized growth rate, in 50 years, Joey will have $2,439,173.58 ($300,000 contributions, $2,139,173.58 in interest/appreciation).
IN 50 YEARS, OVER $2 MILLION IN APPRECIATION! THIS IS THE POWER OF COMPOUNDING INTEREST!!! Starting young gives the kids time. Time is all you need with compounding interest.
THE BEST TIME TO START INVESTING IS NOW! DON’T WAIT!
Please note, you are still bound by the IRS maximum of contributions to your Roth IRA, 401(k) and Roth 401(k) plan.
What if I am over 50 years old?
Based on the 2021 tax code set by the IRS, the maximum contribution to a 401(k) is $19,500 if you are under 50. If you are over 50, you are given a “catch-up” opportunity of an additional $6,500 for a total maximum contribution of $25,000 annually. Please note this maximum is the total for combined contributions to ones 401(k) and Roth 401(k).
Imagine putting in after tax dollars and it grows over many years tax free. What a blessing and gift to yourself in your retirement!
Should you contribute to a Roth IRA?
In addition to the Roth 401(k), there is also the Roth IRA or Roth Individual Retirement Account. Now you might be asking, “well if I put money in my Roth 401(k) at work, can I also put money in a Roth IRA?”
Yes, you can! The Roth IRA is another after tax investment vehicle that you can use for retirement savings. There are additional factors being able to put money into a Roth IRA, but I will explain all of this in further details.
The Roth IRA is like the Roth 401(k) because in both accounts, you contribute after tax dollars. The accounts both grow tax free! Tax free into the account equals tax free out of the account! BOOOYAAA!!
Now you might be thinking, “let me put tons of money in these Roth accounts!” well that would be nice, but the IRS limits the contributions in your Roth IRA, just like in the Roth 401(k). Remember, your contributions to your Roth IRA are non-deductible – meaning you do not get a tax break.
Based on the IRS rules for 2021, the maximum you can put into a Roth IRA is set at $6,000. If 50 or older, you are eligible for a “catch-up” contribution of an additional $1,000, for a total of $7,000.
Unfortunately, the IRS has some limitations to the Roth IRA (not cool when someone ruins the party!).
Based on the IRS rules for 2020, there are income limits, whereby you are ineligible to contribute to a Roth IRA. Check out the IRS site for the breakdown of contributions you could make based on your income: Amount of Roth IRA Contributions That You Can Make For 2021 | Internal Revenue Service (irs.gov)
Aren’t there income caps to the Roth IRA?
You might be thinking, “I make too much to contribute to a Roth IRA, but I want to take advantage of this tax free growth… what can I do?”
Let me tell you about a little secret…
Even if you make too much money, you still can contribute to a Roth IRA…
There is another option, that is completely legal, set by the IRS. The wealthy individuals who make too much money take full advantage of this loophole.
I am talking about a Backdoor Roth. The Backdoor Roth is a strategy where you convert a Traditional IRA to a Roth IRA.
Steps behind the Backdoor Roth Strategy:
- Open a Traditional IRA
- Open a Roth IRA
- Contribute the maximum of $6,000 ($7,000 you are if above 50 years old) to your TRADITIONAL IRA (as a non-deductible contribution)
- Complete an IRA to Roth Conversion or Backdoor Roth
- Please note, you will have to pay taxes during tax season of this amount
- Now your Traditional IRA will show a zero balance, but your Roth IRA will show the contribution of $6,000 ($7,000 if you are above 50 years old)
- This amount of money can now be invested as you choose and grow tax free
- If you make above the IRS limits for Roth contributions, continue to fund your Traditional IRA each year and complete the subsequent IRA to Roth Conversion or Backdoor Roth!
Check out this good description of the Backdoor Roth IRA on Investopedia: https://www.investopedia.com/terms/b/backdoor-roth-ira.asp#:~:text=What%20is%20a%20Backdoor%20Roth%20IRA.%20A%20backdoor,method%20for%20high-income%20taxpayers%20to%20put%20money%20in
The world of finance and investing can appear confusing, and there are so many loopholes in the system, which I want YOU to take full advantage of in your financial future!
Your financial future is up to you and only you. What are you going to do about yours?
Until next time,
Zach
Lana Salisbury says
Fantastic and informative !!