A short overview of the tax strategies of the wealthy; IRAs.

*Not financial advice - your money, your choice*

One of the first pieces of advice I got when I asked mentors and family members what to do to start investing was to open an IRA... the reasons they gave was that it was a way to pay fewer taxes and make money tax-free.

That was all interesting to me but I had one question; what the HELL is an IRA??

As it would turn out, there are many types of IRAs (Individual Retirement Account btw).

From Trad. (Traditional) IRAs to Roth (named after U.S. Sen. William Roth) IRAs and SEP IRAs I'll share what I've learned as well as what I've done.

The type of IRA I use is called a Roth IRA. A Roth IRA is, generally, more flexible than most other types of IRAs. This is because the Roth designation allows you to make withdrawals BEFORE retirement age (59.5 as of June 2022).

How to use a Roth IRA if you're younger than 59.5:

One of the things that excites me about a Roth IRA is that after 5 years (from first deposit) I can avoid taxes on earnings if I...

• Use the withdrawal for a first-time home purchase (up to $10k)

• Pay for qualified education expenses (textbooks, tuition, etc.)

• Use the withdrawal to pay for qualified birth/adoption expenses

• Use the money to pay for unreimbursed medical expenses or health insurance if unemployed.

• If the distribution is made in equal periodic payments

• If you become disabled/pass away

Read more on withdrawal rules here.

The really cool part is that if you're under 59.5 you may ALSO be able to avoid penalties in these situations:

• You're a first-time home-buyer (can take out up to $10k)

• You use it for qualified expenses related to birth or adoption

• You use it to pay for unreimbursed medical expenses OR health insurance if you're unemployed

• The distribution is made in equal periodic payments IF the account has been open for 5+ years

• You become disabled/pass away

That said, if you’re under 59.5 avoid this:

• Taking money made out of your Roth IRA out before you're 59.5 or before the account is 5 years old

• Your earnings may be taxed at your current income and you may be additionally penalized

If you're a single filer making under $128k Modified Adjusted Gross Income (basically your income minus: some tax-deductible expenses for self-employment, business expenses, HSA expenses, education, alimony, etc.):

• You can contribute up to $6k/yr (tax year 2022) or $6.5k/yr (tax year 2023) into your IRA accounts (Roth or Trad.).

  • This could be $2k to a Trad. IRA and $4k to a Roth IRA; just need to not exceed $6k (tax year 2022), $6.5k (tax year 2023) total.

• The amount you can contribute to a Roth IRA diminishes between $128k and 144k.

  • What I would do (not financial advice) if I made $133k is to max out the Roth IRA contribution, based on the table later in this article, and put the rest of the $6k (tax year 2022), $6.5k (tax year 2023) into a Trad. IRA because the Roth IRA is more flexible.

A quick overview of the rules if you're older than 59.5:

• If you withdraw before the five-year holding requirement your earnings (money above the amount initially invested) will be subject to short or long-term capital gain tax but NOT penalties.

• If you withdraw after the five-year holding requirement, then you can take money out of a Roth IRA with NO taxes OR penalties.

• There are also no required minimum distributions (minimum withdrawal amounts) with Roth IRAs like there are with Trad. IRAs.

• Something to keep in mind is that, even if you make over the income limit for a Roth IRA, you can perform a Backdoor Roth conversion where you transfer money out of a Trad. IRA into a Roth IRA (more on that in another post).

Here’s a couple of great tables (tax year 2022 & 2023) from Charles Schwab to simplify things:

Go deeper on a Trad. IRA here.

When talking with a friend it became clear that it's not always clear what to do with the money once it’s in an IRA account.

They initially thought that all you had to do was deposit money into the account and it would grow... this is not true.

If you don't use the money to buy stocks, bonds, or other securities then it will just sit in cash; defeats the purpose of using the account. If you're not sure what 'stocks, bonds, or other securities' are then check out our intro to investing article!

If you want just to have cash - find a high-yield savings account where you can earn a few percent in interest.

If you're interested in learning more or signing up for an IRA here's a link to Charles Schwab (NOT SPONSORED; they offer a great Roth IRA product that I use!).

You can also read more about a Trad. IRA in one of my future blog posts.

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