Source: 401kcalculator.org via flickr
While the financial media regularly offers advice on how to save money for retirement, not much of it covers how to manage your money after you retire. To fill this gap, I suggest using a Roth IRA, which allows your contributions to grow tax free.
What is a Roth IRA and how does it work?
When it comes to investing in an IRA, you have two main choices: traditional or Roth. With a traditional IRA, your money is contributed on a pre-tax basis, meaning you might be able to deduct contributions from your current taxable income. On the other hand, a Roth IRA does not allow you to deduct your contributions, but any qualifying withdrawals are exempt from taxation.
In any IRA, your money is allowed to compound tax free. In other words, you won't have to pay taxes every year on capital gains resulting from the sale of securities or on any dividends you receive.
Am I eligible to contribute after I retire?
One of the requirements for contributing to an IRA is that you must have earned income. Under the IRS' definition, earned income includes any wages you earn or any self-employment income you earn. By contrast, this excludes income from interest, dividends, Social Security, and pension plans.
As a general rule, if you receive a W-2 or fill out a Schedule C with your tax return, you can make Roth IRA contributions. If you have earned income, you are allowed to contribute 100% of your earnings up to the $6,500 annual limit ($5,500 plus $1,000 since you're over 50). In other words, if you earn $2,000 from a part-time job or from your interest in a business, you can contribute up to $2,000 to an IRA.
The maximum amount of earned income you can have to be eligible to make a full contribution to a Roth IRA is $116,000 ($183,000 if married filing jointly). As you'll see, a Roth IRA is an excellent option for retirees who don't need the money in their account in order to live comfortably, but who want a good way to put that money to work for their (or their heirs') future.
Why is it good for retirees, even if you can't make new contributions?
For starters, a Roth IRA doesn't require you to begin taking distributions when you reach a certain age, like traditional IRAs and 401(k) plans do. So, even if you're ineligible to make new contributions, you can still take advantage of tax-free compounding by leaving the money in your Roth IRA for as long as you'd like.
Another thing to consider is that with a traditional IRA, you can no longer make contributions once you begin taking required minimum distributions at age 70 1/2. On the other hand, you can contribute to your Roth IRA for as long as you want. That makes a Roth IRA a great option if you want to keep your money growing tax free throughout your retirement, or to accumulate a nest egg to leave to your heirs.
Also, you don't have to worry about your money being tied up in case you need it later on. Since you're already beyond the retirement age, you'll be free to withdraw your contributions and investment gains whenever you want. If you don't need the money in your Roth IRA now, but find you need it in a few years, you'll have full access to the funds.
Finally, one of the most compelling reasons to use a Roth IRA also applies to pre-retirees -- the tax advantages. By allowing your money to continue to compound tax free, you'll have more money later on in retirement than if you kept your excess money in a taxable brokerage account.
A final thought
The advice here only applies if you have extra money in retirement, and don't need the money in your Roth IRA for something else. However, using the flexible rules of a Roth IRA to your advantage even after you retire can be an excellent way to plan for your later years of retirement, as well as for the financial futures of your loved ones.
