The Benefits Of A Roth IRA For Retirement Planning

Given you cannot withdraw from a 401(k) or traditional IRA penalty free before the age of 59.5, it's prudent to contribute to a Roth IRA with post-tax dollars if your company offers a Roth IRA and if your income is under the limit.

If you are single, you must have a modified adjusted gross income under $153,000 to contribute to a Roth IRA for the 2023 tax year, but contributions are reduced starting at around $138,000. If you are married filing jointly, your MAGI must be less than $228,000, with reductions beginning at $218,000.

A Roth IRA is great for retirement planning if you pay the 24% federal income tax bracket or lower. Once you start paying a 32% federal income tax rate, it gets hard to pay tax up front to contribute to a Roth IRA. Remember, you will likely earn less in retirement than while working.

2023 federal income tax brackets for singles, married

The Roth IRA Strategy For Early Retirement

For those of you in the 24% federal income tax bracket, who plan to retire before the age of 59.5, the age where you can withdraw from your 401(k) and IRA penalty free, then you should definitely contribute to a Roth IRA. For 2020, the maximum contribution is $6,000, and $7,000 for “catch up” if you are over the age of 50.

Every early retiree should do the following:

  1. Max out their 401(k) and IRA
  2. Max out their Roth IRA
  3. Build an after-tax retirement portfolio that spits out passive income
  4. Negotiate a severance to give you a financial runway instead of quit

Steps 2-4 are critical to sustain an early retiree's lifestyle given 401k and IRA money can't be touched until 59.5

Even though I was able to successfully retire in 2012 at the age of 34, I made the mistake of not taking full advantage of the Roth IRA while I had a chance. I scoffed at contributing just $2,000 to a retirement savings account back in 1999. Instead, I just contributed $10,500 to my 401(k) instead.

The IRA maximum contribution limits have increased over time. They started in 1975 with a $1,500 limit from 1975-1981, $2,000 limit from 1982-2001, $3,000 limit from 2002-2004, $4,000 limit from 2005-2007, $5,000 limit from 2008-2012, $5,500 limit from 2013-2018, and now $6,500 for 2023, and $7,500 if you are older than 50.

Because Roth contributions can be withdrawn without penalty (again, not the gains, only your original cost basis), Roth accounts essentially serve as an added contingency or emergency fund.

Income-Tax and Penalty Free Roth IRA Withdrawal

It's important to clarify further when you can withdraw from a Roth IRA without penalty.

1) The first requirement is that the withdrawal must be taken five years or more after the account was opened. The IRS counts the five years from the first day of the tax year in which you make your first Roth contribution. In other words, if you open the account on Dec 1, 2019, the IRS actually starts the clock at the beginning of the tax year, that is, Jan. 1, 2019.

2) If you satisfy the five-year time requirement, the IRS says distributions qualify to be both income-tax and penalty free if:

  • the money is used to buy, build or rebuild a first home, up to a $10,000 maximum that is spent within 120 days of the withdrawal
  • the money is withdrawn because you suffered a disability
  • the money is distributed to your beneficiaries or to your estate after you die

When a withdrawal fits these requirements, it is called a “qualified distribution.”

Penalty Free: Higher Education and Medical

Certain other withdrawals still require you to pay income tax, but the IRS won’t punish you with an additional 10 percent early withdrawal penalty. The most common is for higher education expenses.

You don’t have to pay the penalty if the withdrawal is for less than or equal to the amount you pay that year for tuition, books, room and board, etc.

Some kinds of unreimbursed medical expenses also qualify. It's always best to check with the IRS website for more information.

historical Roth IRA contribution limits

Roth IRA Is Just One Strategy For Early Retirees

Since leaving my job in 2012, I've been able to keep all my retirement funds intact earning compounded returns. In other words, not one dollar has been withdrawn from my retirement funds to pay for my lifestyle. Please note there are disadvantages to a Roth IRA as well.

You will find that as an early retiree who has been aggressively saving all these years, drawing down principal will feel like a terrible sin. As a result, you do everything possible to avoid doing such a thing.

Although my severance package could have paid for 5 years of living expenses, I invested all of it in the market every time some deferred cash or stock compensation came due. Meanwhile, I invested all of my after-tax passive income as well.

The key for staying retired was really finding something I loved to do, which is to write on Financial Samurai. I started this site in 2009 during the middle of the financial crisis because I was scared of losing all my money.

Instead of smoking or drinking, I decided to find therapy in writing. The more I wrote, the more this site grew. After I left work in 2012, I wrote even more. And now, this site earns a nice semi-passive income stream through advertisement revenue. Maybe you want to start your own site one day and stay connected to like-minded individuals.

In retirement, all you really need is to make a fraction of what you were making when working full-time to live a comfortable life. Once you've got your housing costs and healthcare costs squared away, retirement life is cheaper than you think.

Use a Roth IRA to help diversify your retirement needs. Hopefully, you'll never have to touch your Roth IRA, traditional IRA, and 401(k) in retirement because you're too busy living within your means. But in case of an emergency, a Roth IRA can certainly help provide you that buffer you're looking for.

Save aggressively and invest often. You will not regret your decision to delay gratification in exchange for financial freedom!

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