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As 2020 began, the economy was roaring, and seemingly the good times would never end.  When we least expected it, we were all thrown a curveball by the pandemic.  Many have lost jobs and/or have seen their business struggle mightily. It’s at times like this when flexible access to your cash and investments is very important.

Whether you’re employed or a business owner, or both, you’re likely familiar with the various retirement accounts available to you.  The most famous would be the traditional 401k, where employees can contribute pre-tax dollars.  For small business owners, you may contribute to a SEP IRA or SIMPLE plan.  These are all great retirement options that we strongly recommend.

In addition to these other retirement vehicles, we believe that everyone eligible to do so should also have a ROTH IRA as part of their overall retirement savings strategy.  As we’ll cover below, a Roth IRA is a powerful, versatile, and tax-advantaged savings tool that is perfect for an inevitably uncertain future.

How does it work?

With a Roth IRA, you contribute AFTER-TAX dollars.  Accordingly, since you’ve already paid tax on the money you contributed, you never pay tax again.  This includes allowing for tax-free growth of your investments.

For example, let’s say at 30 years old, you decide to open a Roth IRA.  You elect to contribute $6,000 annually (which is the current 2021 annual contribution limit).  Further, let’s say you go on to contribute $6,000 annually until you reach the Roth IRA retirement age of 59 ½.  For this calculation, we’ll assume you invested in a diversified stock index fund, and we’ll assume a conservative 6% annual expected rate of return.  Under this assumption, you would have contributed a total of $180,000 in after-tax dollars.  Your account balance at age 59 ½ would be $500,000.  This amount, both the $180,000 in contributions and the $320,000 in investment gains, will NEVER be taxed.  Not a bad deal, right?  With a Roth IRA, what you see is what you get; every dollar of your balance is yours to keep.

For all the stock pickers out there, if you had invested $1,000 in the Microsoft IPO in 1986, your investment would be worth approximately $1.7 million today.  If you made that investment within a Roth IRA, your $1.6 million investment gain would be totally tax-free.

The benefit of the Roth IRA over other retirement vehicles:  Flexibility

Other than facilitating tax-free investment growth, the Roth IRA’s main benefit is flexibility, including the option to withdraw funds before retirement age if a need arises.  Since your contributions are made with after-tax dollars, you can withdraw contributions made to your Roth IRA anytime, tax and penalty-free.  This hopefully quells some of the hesitancy that people feel in committing to retirement savings, as your money isn’t quite “locked away” like in other retirement vehicles. 

For example, let’s say you contributed $10,000 in total to your Roth IRA.  Further, let’s say over two years that $10,000 has grown to $15,000.  You now have $10,000 in contributions and $5,000 in earnings.  You can withdraw any amount up to $10,000, tax and penalty-free, at any time.

It’s for this reason, the Roth IRA is often viewed as a long-term Emergency fund of sorts, as the contributions are there if you need them and can be accessed long before retirement age.  For many people, just the ability to withdraw contributions is sufficient to account for unplanned future needs.  However, in some cases, you may have more significant planned expenses or emergencies requiring the early withdrawal of funds. This would often involve dipping into the earnings portion of your Roth IRA balance.  This can be done, but there are more strict requirements that have to be met.

The IRS has established that the early withdrawal of earnings from a Roth IRA (i.e., a withdrawal that occurs before the age of 59 1/2) is subject to ordinary income tax AND a 10% penalty.  This is understandable as for all the flexibility of a Roth IRA; the main intent is still retirement savings.

However, there are ways to avoid the 10% penalty and, in some cases, the ordinary income tax:  First, to withdraw the earnings portion of your Roth IRA (i.e., your investment gains) before the retirement age of 59 ½, there is a five year holding period from the date of your first contribution.  After this period, you can withdrawal the earnings portion of your Roth IRA, penalty-free (and in some cases income tax-free) for the following reasons:

  • The Roth IRA can be used as a savings vehicle for planned expenditures:
    • First-time home purchase

You can withdraw up to $10,000 (in total) towards the purchase of your first home

  • To cover qualified education expenses

Similar to a 529 plan, the Roth IRA can be used to save for college tuition costs for you, a spouse, your children and/or grandchildren

  • You can use the withdrawal for qualified expenses related to a birth or adoption
  • The Roth IRA can also be utilized for emergencies, for example:
    • Funds can be withdrawn if you become disabled or pass away
    • You can use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.

NOTE: You should always consult with a tax professional to confirm that your specific scenario qualifies for tax/penalty-free treatment before initiating a withdrawal of your Roth IRA earnings.

Flexible Withdrawal Options in Retirement

So far, we’ve covered some of the early pre-retirement withdrawal options.  However, once you reach Roth IRA retirement age (59 ½), another benefit is there are no Required Minimum Distributions (RMDs).  All other retirement accounts (401ks, Traditional IRAs, SEP IRAs, etc.) require the account owner to begin withdrawing funds from their account at 70 ½ years old.  With a Roth IRA, you have the flexibility to withdraw only when you want to, making this a great wealth transfer vehicle.  If you decided to leave your account untouched, your heirs can enjoy tax-free distributions of the inherited funds.

What’s the catch?

First, it’s important to note; the Roth IRA is not meant to be your only retirement account; instead, it should complement other more robust retirement vehicles (such as a traditional 401k, SEP IRA, etc.).  Since Roth IRA annual contribution limit is low (currently $6,000 for 2021), you will likely not be able to contribute enough to generate sufficient income for retirement.  Therefore, we recommend pairing the Roth IRA with other retirement vehicles such as a traditional 401k, SEP IRA, etc.

When contributing to a Roth IRA, you must be aware of your income level to determine if you are eligible to contribute to Roth IRA.  In 2021, if you file taxes as a single person, your Adjusted Gross Income (AGI) must be under $140,000 or $208,000 for those married filing jointly.  

The Bottom Line

To be clear, withdrawing funds from a retirement account should always be your absolute last resort.  These accounts are designed for long haul savings and perform best when left untouched until retirement age.  However, we feel that a Roth IRA fills the gap between a regular taxable brokerage account/savings account and traditional retirement savings vehicles by allowing you unrestricted access to your contributions and many options to access your earnings if needed.


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