Why the Roth IRA is Both a Beauty and a Beast for Investors

by | BiggerPockets.com

The Roth IRA is a beautiful creation that works like a beast. Know the primary benefits of Roth ownership, and learn to let this account work for you. Here is the quick and dirty of the Roth IRA.

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Why You Want One

A Roth IRA is purchased with income that has already been taxed. You can write this off the year you pay those taxes. The genius of the Roth IRA is that you don’t pay taxes on those funds ever again. You don’t pay taxes on the growth or the withdrawal. This is a wonderful long-term investment plan.

What you don’t know, because you aren’t paid to know, is that there are a whole host of ancillary benefits that ride the coattails of these beauties. So, if the first motivator I’ve offered to buy an IRA isn’t enough, here are some of the other beautiful features of this beast.

Related: How to Grow Your IRA From $5,500 to $204,345 With a Single Rental Property

Traditional verse Roth IRAs

First, your traditional retirement plan is subject to required minimum distributions.

With traditional IRAs, you have to take distributions. You also have to take tax on them from the time you reach 70.5 (seventy-and-a-half) years old. Roth IRAs, by contrast, can just keep growing.

Let me tell you a little bit about my friend Rhonda. She’s making enough money off of her aquarium supply business that she’d just as soon leave her money in the bank. She can keep accruing growth for a dream vacation, a luxury retirement condo, or even a nest egg to leave her family. Rhonda is married with two children, so one feature of her account will protect her loved ones in the event of an untimely death.

But That’s Not All

This leads to the next major benefit: A surviving spouse can keep feeding a Roth IRA or combine it with an existing Roth IRA. Rhonda’s husband would not reap this benefit from a traditional IRA account. A non-spouse beneficiary, like Rhonda’s daughter Rosie, cannot continue to grow the account. They can, however, delay the required minimum distributions. For five years, they can ride those tax-free returns.

As a second option, you can choose a lifetime expectancy distribution. Setting aside the morbid reality that this will require you to consider your own mortality, it will provide the best option for a non-spouse beneficiary who wants to keep as much money as possible in the Roth IRA (where it will continue to grow tax-free). This brings peace of mind to both Rhonda’s daughter, who hasn’t been as successful as her yet, and Rhonda herself. Death is inevitable, and nobody tells you when the Reaper is coming. However, you can certainly financially outmanoeuvre him.

Related: Why You Need to Start Your IRA NOW…and Any Other Tax-Free or Tax-Deferred Vehicle You Can

Finally, Roth IRA owners are not subject to the 10 percent early withdrawal that is comprised of contributions or conversions. Rhonda, because she’s a genius, took care of her money early. When she hit 56, it was time to go on her dream vacation. She never took the 10 percent hit because she planned for her early retirement with a Roth IRA.

If she wanted to avoid the taxman, Rhonda couldn’t touch her growth or earnings. She had to wait five years for the conversions. However, she took a lot of investment capital out tax-free, then reinvested it in a new business to further insulate her against the government’s sticky fingers.

There are definitely some requirements to qualifying for a Roth IRA, but you can convert existing funds and get started straight away.

Let your money grow in a Roth IRA. Be a beast, and your retirement will be a beauty.

Are you using a Roth IRA and loving it? Tell me about it in the comments below!

About Author

Scott Smith

Scott Smith helps clients nationally and internationally from his office in Austin, Texas. With over 5 years experience in the litigation, Scott works on proactively building defense in anticipation of future lawsuits for real estate investors. Scott is one of the few attorneys in the nation that structures companies for maximum protection with minimum taxes.

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10 Comments

  1. Cindy Larsen

    I agree, the roth IRA is beautiful, and I love it. Everyone should have one.

    The biggest problem is that you can only contribute $5,500 per year, and
    only if you have w2 income of at least $5,500/year ($6,500/year if you are
    over 50). Imagine rental properties owned in your Roth IRA providing a tax
    free income stream in retirement 🙂 Sadly, you can not contribute for past
    years when you didn’t know about the Roth IRA. So start contributing now,
    and max out your contribution each year.

    Roth Ira is the best investment vehicle ever invented. No income tax, no
    capital gains tax, no required minimum distributions that get taxed at your
    highest marginal tax rate.

    The problem is, how do you get more of your money into the roth?
    (Disclaimer, I am not a financial advisor, not a tax professional. Anyone
    who knows more than I please correct anything I get wrong)

    Here are three strategies:
    1. Contribute for 2017 NOW. You have until you file your 2017 taxes to make
    your 2017 contribution. You can make your 2018 contribution now as well,
    and invest the money tax free in almost anything, including real estate.
    Contributing early each year gives that tax free investment money more time to grow.

    2. Convert traditional IRA or 401k funds to your roth IRA, and pay the
    income tax on the conversion amount out of pocket, if at all possible.
    I convert the difference between my adjusted gross income and the
    top of my tax bracket every year. If the money grows in my 401k, it will
    someday be subject to RMDs: both the retirement funds I have now,
    AND their future growth will all be taxed eventually, a larger RMD
    each yearuntil there is NOTHING left in my 401k or traditional IRA.
    By converting small amounts every year, I can choose my tax rate on
    the 401k funds, and the future growth will NEVER be taxed.
    I’ll be paying 25% of this year’s conversion amount to the irs. Better
    a small amount now than a larger amount of tax to be paid later
    when my retirement funds have doubled or quadrupled.

    3. Create a side business as an S-corp, with yourself as a W2 employee
    of your S corp (you also get to wear owner and CEO hats. Your S-corp can
    have a solo 401k, to which you can contribute. I believe that total individual
    Retirement contributions are limited to $18,000/year. So, the plan would be,
    from your regular W2 job, you can contribute to the ROTH IRA up to the max,
    say $5,500. In addition, whatever W2 income you generate via your S-corp
    (minus your Roth contribution) up to $18,000 can then be contributed to
    your solo401k. You can also, wearing your S-corp CEO hat, choose to contribute
    to each employee’s 401k up to 25% of the w2 income they earned. This maxes
    out at $54,000, I think.

    Example: your side business earned $35,000, of which $20,000 was
    your before tax W2 income. You contribute $12,500 of this $20,000
    to your solo401k, and the remaining $7,500 is subject to FICA,
    unemployement tax, income tax, etc.
    The s-corp business income of $35,000 has $20,000 salary expense plus
    an expense for employer FICA tax of 7.5% of $7,500 = $562. After all other
    business expenses are subtracted from the income, the profit for the s-corp
    business is, say, $6,000. You can choose to distribute that income to the
    business owner (yourself), and pay income tax on it, or you can contribute
    up to 25% of W2 income to your employee’s solo401k. This would be 25% of
    the $20,000 W2 income = $5000. Total contributions to your solo401k are
    $12,500 employee + $5000 employer = $17,500. You can then convert this
    $17,500 to your Roth IRA, paying income tax (say 25%) on the conversion
    amount, out of pocket.

    Roth IRA Total: contributed $5,500 + converted $17,500;= $23,000.
    Total this s-corp side business added to your taxable income for the year:
    $17500 converted solo 401k funds that became taxable income +
    $7500 W2 income +
    $1000 profit distribution to business owner
    Total = $26,000, taxed at your marginal tax rate.

    At 25%, this would be $6,500, which is probably slightly more than
    your taxable income from the s-corp, so you don’t actually get to
    keep any of the income from your s-corp side business in your
    pocket: it all went for expenses, taxes, and into your Roth IRA, to
    invest for your retirement. Even though, on paper, the s-corp business
    made a profit of $1000, and paid you for your time, in reality,
    what you got for your time was $17,500 into your Roth IRA.

    Result: you got to increase your Roth IRA funds by $23,000 instead of only $5,500

    Fun fact: you can do this even if you are retired, doing something you enjoy, and
    keeping busy being your own boss. And a lot of the money you earn, (half in this
    example) you can invest tax free. When you need to, you can live off of the profits
    of those tax free investments, and pay zero taxes on that increased retirement income.
    For life.

    The good news is people are living longer. The bad news is very few people have
    enough retirement income to last out those longer lifespans and social security
    only provides for a poverty level standard of living. We have no choice but to
    provide for our own retirement.

    I really love the Roth IRA. Everyone should have one. We all need a tax free income stream 🙂

    • Vitaliy Volpov

      Cindy,

      Nice breakdown! I might suggest a variation: set up the Solo 401k in your example as a Roth 401k with checkbook control where you can invest in real estate using the Solo 401k funds. Then buy great real estate deals which will give you the opportunity to supercharge your tax-free profits faster.

    • Samuel Kwak

      Thanks for sharing the insights Cindy! I learned a great deal as you articulated Roth IRA and it’s potential through a solo 401k. I was curious about it and had hazy understanding of it but you clarified it. Appreciate your input!

  2. Jessie Silva

    If you are looking to invest in real estate and take out a bank loan through your self-directed IRA account to invest in a property – wouldn’t you pay UDFI taxes (up to 39.6%) on any taxable income generated from that debt?

    To me it seems like HUGE taxes will be imposed on you if you borrow/leverage the banks money to fund your real estate investments. Correct me if i’m wrong. Although it seems like a Solo(401k) does not impose UDFI taxes.

    Also note that Solo(401k) accounts only allow you to borrow up to 50% of your total account balance (but no more than $50,000) to invest in assets. And you can’t have full time employees either, otherwise your ineligble to maintain your account.

    From what I can see, it seems like a Solo(401k) offers more benefits and superiority than other self directed accounts. Then again, these retirement accounts have there limits. But overall useful to some degree.

    • Scott Smith

      Hi Sam, I’m glad you found this helpful. I actually have a series of articles on the 401k, including some answers to FAQs. I’ll be publishing that soon for the community, so just add me to your network and you should be able to find it. You can also inbox me if you have a specific question. You can also keep your eyes peeled for some of my future content, as I’m about to give away an eBook that has information from here on BP and some other investing basics and tips.

  3. Let’s back up a second here. (Hi, I am new to this site…hello everyone!)

    In order to qualify for the ROTH IRA your household MAGI has to be less than 199K (186K is full deduction with phase-outs till 199K). So if you make more than 199K, you’re out of luck. You can contribute “After-Tax” to a Traditional IRA, and then do a “Back-door Roth)
    Ref: https://www.rothira.com/what-is-a-backdoor-roth-ira

    To the best of my knowledge, you are allowed a tax-free exchange from your Traditional to the Roth on the amount invested, not the gains on the tax-free deposited money.
    Please let me know if I am mistaken. Thanks.

  4. William B.

    Nice article Scott, would like to see you write one that goes something like this: “What a google search of Roth IRA vs. Self Directed IRA doesn’t breakdown, here is what you need to know” or something like that.

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