Properly used, a Roth IRA can be an incredibly powerful tool for your retirement. Once in your Roth IRA, your money can grow tax-free inside that account for the rest of your life. Plus, once you're eligible, if you need to tap the money, qualifying withdrawals are also completely tax-free.
As awesome as a Roth IRA can be, however, those two words -- "properly used" -- make all the difference when it comes to getting the most out of the plan. All current and prospective retirees should know these three tips to be a Roth IRA millionaire.
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No. 1: Start early
Roth IRAs have a handful of "five-year rules" you must abide by to get your money out of them completely tax-free. One of those rules is that in order to withdraw your earnings tax-free, your Roth IRA must have been open and funded for at least five years. That rule holds true even if you are above age 59 and a half and would otherwise qualify for tax-free withdrawals.
As a result, it's important to start getting money into your Roth IRA early to keep that five-year rule from becoming a barrier to withdrawing cash once you've reached a standard retirement age.
No. 2: You can get money into a Roth IRA through a 'backdoor'
Strict income limits make it difficult for high-income earners to get money directly into a Roth IRA. Even more challenging, those income limits are based on your modified adjusted gross income, which includes most investment income, such as dividends, interest, and capital gains.
As a result, if your income is close to or over the limits, it can be tempting to not contribute to a Roth IRA or to wait until your income is more certain for the year before doing so. Fortunately, you might still be able to get money into a Roth IRA even if your income would otherwise prohibit it.
This is because of a concept known as a backdoor Roth IRA. Basically, if you contribute to a traditional IRA and then quickly convert the money from the traditional IRA to a Roth IRA, you can get it into your Roth IRA through that backdoor approach.
The backdoor Roth IRA concept works no matter how high your income is, but you do need enough taxable compensation (basically earnings from work) to contribute to your traditional IRA.
No. 3: You can use a Roth IRA conversion ladder to help you retire early
Although generally, you must be at least age 59 and a half to get your earnings out of your Roth IRA tax-free, the rules are much friendlier when taking out your contributions. Money you directly contribute to your Roth IRA can be taken out at any time for any reason without taxes or penalties. Money you put into your Roth IRA via a rollover or conversion from a traditional-style retirement plan can be taken out after it ages in the Roth IRA for at least five years.
In addition, when withdrawing money from a Roth IRA, your direct contributions come out first, then your rollover and conversion contributions in the order you made them. Only after those are withdrawn would you start tapping your earnings.
Those rules give rise to an early retirement funding approach known as a Roth IRA conversion ladder. After you build a decent balance in traditional retirement accounts, you start rolling over that money to your Roth IRA in stages, making a partial shift each year.
By beginning those conversions at least five years before you're ready to retire, you can build up a balance of Roth rollover contributions. Five years after each rollover conversion, you can withdraw the originally converted amount with no additional taxes due on it.
This approach offers a key advantage over other ways to tap your retirement money early in that you can always take less out if you find you don't need all the money you've converted. This contrasts with the other key way to get money out of your retirement plans early without penalties, which is through a process known as substantially equal periodic payments (SEPP).
The downside of SEPP withdrawals is that once you start them, you must continue them until you reach age 59 and a half or have taken at least five years of such payments, whichever is longer. If you later decide to go back to work or discover that your expenses are less than you originally thought, you're still stuck taking out those payments until that timer pops.
Get started now
Used well, a Roth IRA can be an incredible tool to help you manage your money throughout your career and retirement. Especially when you add backdoor contributions and conversions to the mix, it can even help you reach millionaire status.
Still, the biggest benefits that Roth IRAs offer typically have at least a five-year waiting period before you can take advantage of them. So, make today the day you get started on your quest to become a Roth IRA millionaire. The sooner you get started, the sooner you'll pass the first five-year hurdle, and the better your chances are of reaching that goal.
