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How can you become a tax-free millionaire?
Key points
- Roth IRAs don't give you an immediate tax break on contributions, but you get tax-free gains in your account and tax-free withdrawals once you reach age 59.5.
- Roth IRAs are best for younger workers who are in a lower tax bracket and have the time to take advantage of compound interest.
- If you're 20 years old, a one-time contribution of $6,000 into a Roth IRA will grow to just over $700,000 with a 10% annual return by the time you hit 70.
Graham Stephan, best known for videos on financial independence, saving money, and investing money, is an American real estate agent and YouTube personality. In one video, he discusses why you need a Roth IRA and how it was one of the things he wished he would have learned and contributed to when he was younger.
What is a Roth IRA?
A Roth IRA (individual retirement account) is a type of retirement account that you can set up and contribute up to $6,000 per year (for 2022). You don't get an immediate tax deduction like a traditional IRA, but instead the funds grow tax-free and the withdrawals are also tax-free. You can take money out once you hit age 59.5.
According to Stephan, "That means you pay NO TAX on YEARS of compounded interest and earnings. Your tax free profits just makes you MORE tax free profits. And it snowballs into a LOT of money." Not having to pay taxes on your Roth IRA withdrawals is a big deal since many seniors feel squeezed financially during retirement.
The max you can contribute to a Roth IRA can change from year to year. The current max is $6,000 if you're under the age of 50. If you're 50 or older, you can contribute $1,000 more as a catch-up contribution, bringing your max to $7,000.
Who is a Roth IRA best for?
Roth IRAs may make less sense for older workers who are in a higher tax bracket. A traditional IRA may be best for them so they can get the tax deduction upfront. But the younger you are, the more benefits you may see. Younger workers are typically in a lower tax bracket, so it may be more advantageous for them to pay the taxes now and contribute to a Roth.
When you contribute to a Roth IRA, you are locking in your current tax rate on the money you contribute. That way, if you are in a higher tax bracket when you are in retirement, it won't matter -- your money will be yours to enjoy tax free.
In addition, younger workers have more time to take advantage of compound interest. A one-time contribution of $6,000 by a 20-year-old will grow to just over $700,000 with a 10% annual return by the time they hit 70. A 30-year-old who makes the same contribution will grow to just over $270,000 by the time they are 70.
If this money is in a Roth IRA, they only paid taxes on the $6,000 they contributed and the 20-year-old will get to keep the $694,000 profit they made tax-free. This is why Graham Stephan states that you should open up a Roth IRA if it is right for you.
Most major brokerages let you open a Roth IRA. Your goal in opening a Roth IRA should be to find an account that's easy to manage and doesn't have high fees. If a Roth IRA is right for you, compare your Roth IRA choices and start putting money into the account as soon as you can.
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