It's tempting to put retirement savings on the back burner. But delaying your retirement plans can cost you later on. If you end up with a Roth IRA (individual retirement account), there are certain rules you need to meet before you can withdraw 100% of your money tax-free.
Below, I'll review the one rule that you need to check off your list in order to fully enjoy your Roth IRA savings. The earlier you open and fund your account, the sooner you'll be able to gain access to your tax-free treasure.
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Understanding how the Roth IRA works
If you're new to Roth IRAs, here's a quick primer. Roth IRAs are part of a club of accounts called individual retirement accounts. You don't need your employer's blessing to open and manage this account. You'll fund your account with after-tax dollars in exchange for tax-free benefits when you retire.
Time is of the essence. If you wait too long, you may not be able to make direct contributions to a Roth IRA. This account was designed to give low- and moderate-income earners a leg up on their retirement-savings journey. Therefore, you'll have to meet the income threshold to gain direct access to a Roth IRA.
Roth IRAs aren't exclusive to adults. An adult can help a child jump-start their retirement savings by opening a custodial Roth IRA. The only catch is that the child must have earned income in order for an adult to contribute to a Roth IRA on their behalf.
Don't forget the 5-year rule
If you've ever wondered if you should start saving in a Roth IRA now or wait until later, here's something that could make your decision a bit easier: the five-year rule, which determines if you'll pay taxes or penalties on your withdrawals.
There are three key situations that could trigger the five-year rule, but let's focus on how withdrawing earnings from your Roth IRA works. This five-year rule is based on the timing of your first contribution to your Roth IRA. For 2022, you can contribute up to $6,000 if you're under 50 and $7,000 if you're older. Your contribution clock starts on the first day of the tax year you fund your account. If you pull the trigger and decide to make your first contribution in 2022, your five-year period will end on January 1, 2027.
Fortunately, you have up until the tax deadline to contribute to your 2021 Roth IRA. So if you make your first contribution for the 2021 tax year, then your five-year waiting period to access tax-free withdrawals will end on Jan. 1, 2026. You can always take out what you've contributed to your Roth IRA tax-free, so this rule is geared toward the earnings in your account.
After you reach 59 1/2, you'll be eligible to withdraw all of your money penalty-free. But you'll still be on the hook for taxes if you haven't passed the five-year-rule test. There are exceptions that would allow you to bypass the five-year rule such as paying for qualified college expenses or making a first-time home purchase.
If you plan to do a Roth conversion or inherit a Roth IRA, there are a different set of rules you'll have to follow to make sure you don't sound off the IRS alarm.
Start working toward the five-year contribution rule now
The last thing you want to happen is to get to retirement and realize you'll be unexpectedly taxed on your earnings. Save yourself the headache by getting a head start on your Roth IRA savings now. You can contribute $100 today or set yourself up to become a Roth IRA millionaire by creating a plan to max out your contributions.
You may even qualify for a nonrefundable Saver's Credit on your current-year tax return when you contribute to a Roth IRA.
Timing is everything
There are many Roth IRA benefits that you can explore now and during retirement. The money in your account can be used to pay some of your biggest life expenses, such as college or homeownership. It can even serve as a last-resort savings fund if you find yourself in a financial rut.
No one knows how long the Roth IRA will be around. The most important thing you can do now is determine if the Roth IRA is the best account for you. If so, then get started on your journey so you can activate the five-year clock. Think of it this way: The sooner you get started, the closer you'll get to your tax-free jackpot.
