A Roth IRA can be an excellent way to save for retirement. You contribute and invest money, your investments can grow and compound tax-free, and you'll pay no income taxes on your eventual withdrawals, no matter how big your account gets.
However, there is more to Roth IRA investing than that simplified explanation. Specifically, here are two other smart uses for Roth IRAs and a way to get around the income restriction if you think you don't qualify to contribute to a Roth IRA.
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A Roth IRA can be a smart way to invest for college
Even if you feel like you don't need to save for retirement in an IRA, you may want to consider one as a college savings vehicle. To be clear, 529 Savings Plans and Coverdell ESAs can be excellent ways to save for college. However, IRAs, and Roth IRAs in particular, have some advantages of their own that you should be aware of.
For starters, although you generally have to be 59 1/2 before you tap into your IRA, there is an exception that says you can use any amount of money from your account to pay for qualifying higher education expenses, penalty-free. Your original contributions can be withdrawn tax-free, but the earnings from your investments will be counted as taxable income, unless you're over 59 1/2.
You also have the flexibility to use the money for other purposes than college. Funds in a 529 or Coverdell must be used for education expenses or can be subject to a penalty. Meanwhile, if your child doesn't need money from a Roth IRA for college, you can simply use it for your own retirement, or you can withdraw your original contributions at any time and for any purpose. (Note: The ability to withdraw your contributions at any time is the reason I say that a Roth is superior to a traditional IRA to save for college.)
Finally, assets in a Roth IRA (or any other retirement account) are not counted for financial aid purposes. 529 Savings Plans are considered parental assets, and a maximum of 5.64% of the account's value will be counted to determine the Expected Family Contribution (EFC). This isn't a large amount, but the Roth exclusion is definitely better, and could give your child an advantage in the financial aid process.
The best choice for college saving depends on your own situation, and for many people, the other options I mentioned may be the smarter choices. My point, rather, is that a Roth IRA should be considered as well.
They can also be valuable estate planning tools
Here's a Roth IRA tip that can earn your heirs thousands.
One of the unique features of Roth IRAs is that unlike most other retirement accounts, there is no requirement to start taking distributions from the account after reaching 70 1/2 years old. Since you've already paid tax on your Roth IRA contributions before you made them, the IRS doesn't really care how long you leave your money in your account. You can leave your Roth IRA alone to grow until you're 100 years old if you choose to do so.
Because of this, Roth IRAs can be excellent estate planning tools. Your Roth IRA can grow tax-free indefinitely, and can then be left to heirs to produce a lifetime of tax-free income for them.
Consider that if you contribute $5,000 into a Roth IRA every year from the time you're 35 until the time you retire at 65, your account could grow to $472,000 based on a historically conservative 7% rate of return. If you leave this account alone, it could grow to nearly $1 million by the time you're 75, and by your 85th birthday, you could have more than $2 million. Without having to worry about paying capital gains or dividend tax, Roth IRAs can really build up if left alone for long periods of time.
Once your IRA is inherited, your heirs will need to begin taking annual distributions.
Even if you make too much, you can still invest in a Roth IRA
You can't earn thousands in a Roth IRA if you can't contribute to one -- or can you? To contribute directly to a Roth IRA, your adjusted gross income (AGI) cannot exceed a certain threshold that depends on your tax filing status.
For 2017, to make a full contribution to a Roth IRA, your AGI must be less than $118,000 if you're a single filer or $186,000 if you're married filing jointly. If your AGI is above this, you could make a partial Roth contribution, but it phases out entirely above AGIs of $133,000 and $196,000 for single and joint filers, respectively.
What you may not know is that exceeding the limit doesn't necessarily mean that you cannot contribute to a Roth IRA. There is an IRS rule that allows anyone to convert a traditional IRA to a Roth IRA, regardless of income.
Known as the "backdoor" method of contributing to a Roth IRA, the procedure simply involves contributing money to a traditional IRA, and shortly afterward, filing the paperwork to convert the account to a Roth IRA. As long as you haven't already taken a tax deduction for any of the traditional IRA contributions, this is generally a quick and painless process, and won't cost you a dime.
