How to Make a Roth IRA Work for You

Legend has it that infamous venture capitalist Peter Thiel turned a $2,000 Roth IRA into a $5 billion dollar tax-free bonanza! The real magic was in the opaque private investments Thiel owned, but the Roth IRA received “oohs and ahhs” because it helped him reap tax free gains.

Now, everyone wants to know how they can do the same with Roth IRAs. Unfortunately, we don’t have the magic formula for creating billion dollar gains. But the recipe for tax free treatment is straight forward, read on below to learn more about how to make a Roth IRA work for you.

What is a Roth IRA

Starting with the basics, what is a Roth IRA? It’s a type of retirement account, specifically an individual retirement arrangement (IRA) account. IRAs come in many types like Traditional, SEP, SIMPLE, and of course Roth, to name a few.

Roth IRA tax benefits

The various IRAs have differences like who can contribute, contribution limits, and the main concern here, tax treatment. For example, Traditional IRA accounts (TIRAs) typically provide upfront tax deductions and tax-deferred growth.

That means contributions into TIRAs are tax deductible and realized gains or income made inside the account are tax deferred while inside the TIRA. However, taxes must be paid when money is withdrawn out of the TIRA. Withdrawals made before age 59.5 may be penalized.

On the other hand, contributions into Roth IRAs (RIRAs) are not tax deductible, so there is not upfront tax benefit. As with TIRAs, gains and income are also not taxed inside of of RIRAs. However, withdrawals out of RIRAs may be tax-free.

To clarify, RIRA contributions were already taxed (there was no deduction), so the contributions are not receiving any special treatment. But gains and income on those contributions were never taxed, and they may receive special tax-free treatment.

Additional RIRA tax benefits include the potential to withdraw principal early without penalty and exclusion from required minimum distribution rules. The unique benefits of RIRAs make them a valuable tool that is widely available to many people. It’s no wonder RIRAs have become so popular.

Other considerations

If it sounds too good to be true, then it’s probably too good not to have special conditions. That’s certainly the case with RIRAs so not everyone can take advantage of their benefits.

For example, there are conditions for withdrawal age (59.5) and minimum holding periods (5 years) for tax-free qualification. There are also restrictions on what can be contributed (earned income only) and income limits for contributors (2023 MAGI under $153k single or $228k married). Details about these conditions are at the IRS website.

Keep in mind, those who are disqualified from RIRA contributions due to income may still access Roth accounts through “backdoor” and “mega backdoor” techniques. We review those topics in a separate article.

For those who are eligible for RIRAs, an important consideration is whether or not a RIRA (or other Roth-type of account) makes sense to begin with. This is because IRA accounts have annual contribution limits so making a RIRA contribution means forgoing a TIRA of the same amount.

Although the RIRA contribution may provide a future tax exemption, it also forgoes a current tax deduction (which a TIRA may provide). The question becomes what is more valuable, a future exemption or a current deduction? Contrary to what some argue, there is no clear, definitive answer.

It depends on a number of variables including income, tax rates, age, and others. People currently in their peak earning years may also face higher current taxes than they will after they retire. In that sense a higher value current deduction (TIRA) may be worth more than a lower value future exemption (RIRA).

The reverse could also be true, but the point is the decision is not as obvious as some think. You should carefully evaluate your individual needs, goals, and circumstances instead of simply assuming that one option is always better than the other.

Summary on Roth IRAs

RIRAs are not some exotic financial instrument that will help you amass billions of dollars. They are fairly common accounts that are available to most people. However, RIRAs do provide a number of unique tax benefits including potential tax-free treatment which will come in handy when you do amass those billions.

In addition to the fact that not everyone may contribute to RIRAs, they may also not be the best option to begin with. All else equal, RIRAs tend to be good options for those with low current tax burden, long-term time horizons, and assets they expect to appreciate significantly in value (as Peter Thiel did).

Of course, that’s just a generic profile and there are always exceptions. As with any important financial decision, you should carefully evaluate your individual circumstances to determine if a RIRA makes sense for your needs and goals.

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HWL