Imagine for a second that you earned one million dollars, that’s great right? The problem though is if that money is being taxed as ordinary income, it means you’re paying up to 37% or about $370,000 of that one million dollars in taxes. And if you live in a state like California, you’re having to pay up to an additional 13.3% in state taxes. This means in total you only get to keep around 49.7% percent of your one million dollars or about $497,000. This means that a majority of your hard-earned money is being taken because of taxes.
But what if there was a way for you to completely avoid paying taxes? This means instead of you giving away half of your million-dollar fortune to the government, you’re keeping 100% of it. Well, as you probably already guessed, there is a way to do it, and it’s by using a Roth IRA.
A Roth IRA is a type of individual retirement account that lets you invest money into the stock market and have that money grow completely tax-free. And of the dozens of different investment account options that you have available to you, the Roth IRA is the only account that has this benefit.
In this article, we’re going to talk about exactly how the Roth IRA works, the requirements for opening one, and then how you can actually open one up yourself. What to actually invest in within your Roth IRA to grow your account from 0 to 1 million. And by the end of this article, you’ll know exactly how you can retire a tax-free millionaire even if you’re starting with zero.
How Roth IRA Works
The way a Roth IRA works is, that you take your after-tax income which is the money that you’ve already paid taxes on, and you put some of that income into your Roth IRA to be invested. Once that money is in your Roth IRA, you actually choose your investments which we’ll talk about soon. After that, any interest that you earn from your investments growing will grow completely tax-free.
The reason your money grows tax-free inside of the Roth IRA is that, remember, that money was already taxed going into the account. For example, if you work a w-2 job, when you get paid taxes are already being taken out of your paycheck. And here’s an actual example. So you start out and you’ve got your gross income, this is the income that you’re receiving before any deductions are taken out. And deductions are things like FEDERAL TAX, FISCA TAX, FICA MEDICARE, STATE TAX, taxes, taxes, and more taxes.
If you have medical insurance through your job or a 401k, those items could be on the list as well because they’re being deducted from your gross income. So you’ve got your federal income tax, your social security tax, medicare tax, and in most cases a state tax. Although, there are several states like Florida, Tennessee, and Texas that don’t have a state income tax. All these deductions are deducted from your paycheck every single pay period, which then leaves you with your net income which is how much you’re actually taking home after it’s all said and done.
This net income is considered the after-tax income, meaning that Uncle Sam and his good friends at the IRS have already taken their cut. So, when you invest your money into a Roth IRA, you’re investing some of the after-tax or the net income.
How Much You Can Invest in a Roth IRA
How much money that you invest is going to be up to you. The maximum that you can contribute to your Roth IRA every year is $6,000 and $7,000 if you’re over the age of fifty. And it is highly recommended that you try your hardest to max out your Roth IRA every year. For most people, this means investing $500 every month for 12 months which equals $6,000. And because the average person in the US starts investing at the age of 29, this gives the average person about 36 years to invest.
If you could invest $500 per month into a Roth IRA at about an 8% average return adjusted for inflation, after 36 years of investing your wealth would grow to about $1.2 million in your Roth IRA. Thanks to the power of compound interest.
compound interest really is the magic here. You see, it’s not enough to save $500 per month in your savings account, you actually have to be investing that money for it to grow. if you saved $500 per month for the next 36 years, you would have saved about $216,000. However, after the average 3% inflation per year, that $216,000 would only be valued at about $74,561.
But if you were instead investing that $500 per month, well, as you saw earlier, even with the 3% inflation your money would still grow to $1.2 million because of compound interest. And compound interest is the interest that you earn not only on your original money but also on the interest earned from your original money. And so you invest your money, and that money earns interest, and then more interest is earned on your original money plus the interest on the original money, and then more interest is earned on top of all of that and then even more on top of all of that and on and on and on.
This right here is compound interest, and it’s the reason why your money is able to start growing so fast. If you’re able to invest long enough and consistently enough you’ll achieve much faster.
Requirements to Open a Roth IRA
I’d like to take a few minutes now and talk with you guys about what exactly are the requirements to open up a Roth IRA. For starters, you have to live in the US, if you don’t live in the US check to see if there are any Roth IRA equivalents in your country. For example, I know that the TFSA, or the tax-free savings account exists in Canada, and it’s basically the same thing as the Roth IRA if not better.
Next, only earned income that’s been reported to the IRS is allowed to be contributed to the Roth IRA. For example, if you’re working a job and they’re paying you under the table, and none of that income is being reported to the IRS, then you can’t invest any of that money into your Roth IRA. Your earned income has to either be equal to or more than what you’re contributing to your Roth IRA. For example, if your earned income is $3,000 per year, then you can’t contribute more than$3,000 into your Roth IRA.
The next rule is, believe it or not, if your income is too high then, you’re not actually allowed to make any direct contributions to Roth IRA. If you file taxes as a single person, then your modified adjusted gross income can’t be over $144,000 in the year 2022. And if you are married, in filing jointly, your gross income can’t exceed $214,000 in 2022.
However, there’s actually a loophole called a backdoor Roth IRA or a Roth IRA conversion that allows you to still invest money into a Roth IRA, even if your income limits exceed the IRS’s maximum income limit. We’ll talk more about what that is and how exactly you can do it at the end of this article.
Setting up Your Roth IRA
When it comes to setting up your Roth IRA, it’s actually a very easy process. First, you need to actually find a broker that offers Roth IRAs. Some of them are Fidelity, Vanguard, Charles Schwab, Webull, and M1 Finance, opening a Roth IRA is going to be very straightforward at any of these brokers. For example, with Fidelity you would just visit their website fidelity.com, click on open an account, then click on the button that says open now underneath the Roth IRA option, and then from there you just go through the entire application process.
With Vanguard, you would just go to vanguardcom, click on personal investors, click on open new account at the very top of the website, and then click on start new account. From there it’s going to ask you a few very basic questions before you land on the overview page which is going to walk you through step by step how exactly to open up an account with vanguard. After that, you click on the button that says continue opening an account, from there you’ll actually be able to choose your account type.
And then if you want to open up a Roth IRA, you would just choose retirement investing, and then click on Roth IRA. Once you click on continue, you’ll just go through the entire application process just like you would with Fidelity. I could go through this with every single broker but you get the point.
What to Consider When Choosing a Broker
The biggest thing that you’ll want to consider in my opinion when choosing a broker is the user interface. Virtually every broker will give you access to invest in the same exact investments, will offer zero commission trading, and will be nearly identical in every aspect except for the user interface. With the older more established brokers like Fidelity, Vanguard, and Charles Schwab, the user interface tends to be a lot more clunky and just outdated.
Some people really don’t care about this because they’re investing long-term, and they don’t even use their broker on a daily basis. But some people do care a lot about this and for those people who want a clean modern user interface, I would recommend going with a modern broker like M1 Finance or Webull.
Roth IRA Investments
Once your Roth IRA is set up, it’s time to actually decide which you’ll invest in within the account. A lot of people will try to overcomplicate this entire process, they’ll make it seem like you have to be some professional stock picker with years of experience before you can actually begin investing in the stock market. But I promise you it does not take an expert to invest successfully in the stock market. In fact, even if you’re a complete beginner who has zero experience investing, you’re brand new to investing you can still easily invest in the stock market and get wealth-building returns.
You do this by investing in diversified low-cost broad market ETFs (Exchange Traded Funds). Examples of this include VOO or the Vanguard S&P 500 ETF. This ETF invests in the entire S&P 500 index, which means they contain 500 of the largest companies in the US. When you invest in shares of VOO, it’s basically like you’re investing in 500 of the best companies in the US all just from simply buying shares of one single ETF.
Another great ETF is VTI or the vanguard total stock market ETF which invests in the entire US stock market and holds over 4,000 different stocks. If you want maximum exposure to the entire US stock market, then you would invest in this ETF. If you wanted to go super broad, you could invest in VT or the Vanguard Total World Stock ETF which invests in over 8,000 different stocks from companies around the world including the US.
Roth IRA Rules
Let’s talk about some of the most important Roth IRA rules. These are things that you absolutely must know about your Roth IRA, otherwise, you risk losing a lot of money in fees and other penalties that are typically associated with the account.
The first rule although it’s definitely not recommended is that you are allowed to withdraw your original contributions within your Roth IRA. Now, what you can’t do are withdraw the capital gains or the investment gains until you reach the age of 59 and a half. For example, if you put $1,000 into your Roth IRA, and then a year later that o$1,000 turns into $1’500. That means you have a $500 investment gain, and that $500 cannot be taken out of the Roth IRA until you reach the age of 59 and a half. Otherwise, you’ll have to pay penalties and taxes on it.
With that being said, though the IRS does make a few exceptions to this rule and the first exception is that you’re allowed to withdraw up to $10,000 from your Roth IRA to buy your first house. You’re also allowed to take money out for qualified education expenses, health insurance premiums if you’re unemployed, and any disability-related expenses, and you’re allowed to withdraw up to $5,000 per year after having a baby or adopting.
Now, of course, I would highly recommend that you avoid taking any money out of your Roth IRA unless you want to completely destroy your long-term investment gains. Compound interest can only work if you leave the money in your account alone, and allow the interest from your investments to continue stacking and compounding over and over again. But if you’re constantly pulling money out of your Roth IRA, not only do you risk having to pay penalties and fees, but you’re also going to stunt the growth of your account because you’re never giving compound interest a chance to truly start compounding.
The Five-Year Rule
Another very important rule is the Roth IRAs 5-year rule which says, once you turn 59 and a half you’re not allowed to make tax-free withdrawals unless you’ve had your account open for a minimum of five years. Say for example that you didn’t open up your Roth IRA account until you were 60, and then you turned 63 and you said to yourself “well Prince, said that I can start making tax-free withdrawals once I turn 59.5. And since I’m 63 right now, then technically I should be allowed to make tax-free withdrawals right?”
Not so fast, because the Roth IRA s five-year rule applies to anybody at any age, it doesn’t matters if you’re 65 or 105. You have to have the account open for a minimum of five years after 59 and a half, to be able to start taking money out tax-free.
Fortunately, for most of you reading, this rule is not going to affect you because you’re not going to wait to start investing in your Roth IRA when you’re in your 90s. And speaking of waiting to invest in a Roth IRA, it’s worth mentioning that there are no age restrictions for opening up a Roth IRA. For example, believe it or not, a baby that was born one second ago can legally open up a custodial Roth IRA, under their parents’ supervision. As long as that baby has earned income, you as the parent can invest that money into their Roth IRA for them.
And if their parents were consistently investing $500 per month into that baby’s Roth IRA, by the time that baby reached 30 years old they would already be a millionaire. Now you’re probably thinking to yourself “Hey Prince, how can a baby have earned income that doesn’t make any sense?”
Perhaps you take pictures of your baby for your business, and you pay them $500 per month to use their pictures, and as a result that baby technically does have earned income that they can then invest into their Roth IRA.
Backdoor Roth IRA
The last thing that I want to talk with you about is a backdoor Roth IRA. As I talked about earlier, the Roth IRA has income limits and if you exceed those limits then you’re not going to be allowed to contribute to your Roth IRA. However, by using a backdoor Roth IRA or sometimes it’s called a Roth IRA conversion, you can still legally contribute to a Roth IRA and take advantage of those lovely tax-free gains.
The way it works is very simple, so instead of you contributing directly into a Roth IRA, you instead contribute into a Traditional IRA, and then you convert that traditional IRA into a Roth IRA.
Now, it’s important to mention that when you do a Roth IRA conversion, you’re going to have to pay taxes when the money converts from the Traditional to the Roth IRA. However, the backdoor Roth IRA doesn’t mean that you’re paying extra taxes when you convert, you’re still paying the same amount of taxes. That’s because when you first deposit money into your traditional IRA, you’re depositing pre-tax dollars, meaning that money has not been taxed by the IRS yet, and so when you convert the Traditional to the Roth IRA that’s when it’s taxed.
Hey, that’s it for this article, I’ll be writing an article on Roth IRA equivalents in other nations, make sure to subscribe to my mail list to get notified when it’s out. Thanks for reading, you guys are truly amazing and I hope you have a beautiful rest of your day or night. Peace and Happy hustling!