The Financial Freedom Account

There is an account that can get you to financial freedom faster. It is the account that, when managed wisely, can open up opportunities for you to truly be the person you were meant to be. It can provide you FREEDOM. The account I speak of is the Roth IRA. When invested wisely and started early, this account can take you to places you might not know exist. Let's take a look at this "magical" account.

First, the basics. You need earned income to contribute to a Roth IRA. The maximum you can contribute in 2023 is $6,500 ($7,500 for those 50 and over). You have until April 18th of 2023 to contribute to your 2022 Roth IRA. You cannot contribute more than you make at a job. The account needs to be 5 years old for the earnings to be qualified. That can get complicated. Learn more here.

Here are more basics. The money grows tax deferred and tax free inside the account allowing your money to compound over time without any tax paid out to governments. You can convert Traditional IRA money over to a Roth IRA, paying tax now rather than later. You can roll money over from a Roth 401(k) or after tax money into a Roth IRA. Learn more about those moves here and here.

When do you start? As early as possible! As soon as a child starts earning money, start a custodial Roth IRA for them. Learn more here. Read how these wise parents funded their child's custodial Roth IRA here. Time is your friend so get started as soon as possible. Can you make too much money to fund a Roth IRA? Yes and no. Learn about the income limits here. Learn about the backdoor here.

Let's take a step back and talk about 2022, income limits and the backdoor. The max you can put in for 2022 is $6,000 if you are under age 50 and $7,000 if 50 and over. The income limits start at $129,000 (single) and $204,000 (joint) for 2022. Those numbers are $138,000 and $218,000 for 2023. Roth IRA backdoors should be avoided if you have any Traditional IRA money. Here is the work around if you do.

Here is the short version on backdoor Roth IRAs. Move all money out of Traditional IRAs, Simple IRAs, and SEP-IRAs either into a 401(k) with your current employer or Roth conversions. That will avoid a tax mess later down the road. Next, contribute the max to a non-deductible Traditional IRA. Keep it in cash and then a week later, convert over into a Roth IRA and invest it. Repeat year after year.

Where? Vanguard, Fidelity or Schwab would be good options for your Roth IRA. Are there bad options? Yes indeed! Bad options would be places where they charge you yearly fees to hold the account and high fee investments. Do not pay a yearly account fee and make sure your expense ratio is very low on your investments (below .1%). This means you own low fee stock index funds or ETFs.

There is now a new way to fund a Roth IRA and that is through old 529 accounts. New legislation makes it legal to transfer up to $35,000 into a Roth IRA (yearly contributions apply so it will need to happen over years) from a 529 to the beneficiary as long as the account has been open for 15 years. This all starts in 2024. This is a great way to fund a Roth IRA with unused college money. Learn more here.

Let's talk about those Roth conversions more. A great way to build up a Roth IRA is to convert Traditional money during your lifetime. The amount you convert has nothing to do with your contribution limits. You can convert as much as you want in any given year or lifetime. My advise would be to convert when you are in the 10% or 12% brackets. See a 2023 federal tax bracket illustration here.

What could be accomplished by someone who got started at 10 years old and continued to feed their Roth IRA for 30 years, maxing it out over time at an average of $8,000 per year with stock index funds earning 9% per year net of fees? That would be $1,188,601 at age 40! All of that would be tax free and $240,000 of that would be contributions that could be used immediately penalty free!

If that same person contributed $20,000 a year (includes the match) to a Roth 401(k) for 20 years and had matching money provided in Roth (new legislation makes this doable), what would that look like in those low fee stock index funds earning the same 9% net of fees? $1,115,290 is the answer. Adding that to $1,188,601 = $2,303,891. Transfer that 401(k) money over to the Roth IRA and "magic" happens!

Now, the entire 401(k) Roth money is qualified (the Roth IRA must be 5 years old) and can be used immediately penalty and tax free just like the initial contributions in the Roth IRA prior to age 59.5. That is $1,355,290 that is available for every day living with no tax or penalty hit when pulled out. That my friend, is Financial Freedom! You can learn more on this rather complicated issue by going here.

Is there an ideal index fund for the Roth IRA? VTSAX (total U.S. market) would be a fine option. My choice would be VSIAX (U.S. small-cap value). Over the last 50 years the total U.S. market returned 10.29% per year. $10,000 turned into $1,498,599. Over the same period, U.S. small-cap value returned 13.59% per year. $10,000 became $6,796,318. Both numbers are before fees. You make the call.

Let's wrap this up. The Roth IRA is the financial freedom account. The earlier you get started, the better. Max it out every year come hell or high water. Convert Traditional to Roth when you find yourself in low tax brackets. Rollover Roth 401(k)s when possible. Invest in low fee stock index funds. VSIAX might be an ideal choice over the long term. Financial Freedom comes to those who learn and do. Take action!

Stuff the lawyer wants me to say: Investing outside a bank or a credit union is not FDIC insured. You may lose the value in the investments you select. All information provided here is for informational purposes only. It is not an offer to buy or sell any of the securities, insurance products, or other products named. Translated: I am not selling anything! Educate yourself, research the information that you learned and finally make the right decisions that will benefit you and your family going forward.

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