The Easiest Tax-Free Account to Open

In my last post, I talked a little about tax-free accounts and how my wife and I are making use of them. So I thought it only fitting to introduce the easiest type of tax-free to open: the Roth IRA. I’m sure many of you have a Roth IRA, or at least have heard of it. But even so, I find there’s a lot of confusion about them.

(Photo by Peter Fazekas from Pexels)

The Roth IRA is one of a number of account types with the IRA (“individual retirement account”) designation. A common characteristic of all types of IRA is that the owner has a lot of freedom of choice in terms of what is housed in the account. Just as almost any dwelling can qualify for Air BNB and almost any car can qualify for Uber or Lyft, almost any investment can qualify to be an IRA. For example, I have a simple brokerage account (for investing in things like stocks, ETFs, and options) that I designated a Roth IRA. I want that level of freedom to choose my investments. But you could just as easily open an account with a low-cost robo-advisor (who will direct how your money in the account is invested) and designate that a Roth IRA. And you could transfer the contents of an existing Roth IRA into an annuity and maintain the Roth IRA designation on that annuity, which would enable you to receive income payments for life without having to pay taxes on them! The possibilities are very wide open.

What separates the Roth IRA from the other IRA types is that it’s the only one that will let you not pay taxes on the profits from your investments and the only one that won't subject you to RMDs later in life. However, these benefits do come with a few strings attached. First, the profits aren’t tax-free right away. There are hurdles that both you and the account have to clear before that can happen. Your account’s hurdle is that 5 years have to have passed since your first contribution. Your hurdle is that you have to be at least 59½ years old. If you tap into the profits before the account has cleared its hurdle, you’ll have to pay taxes on the profits you tapped into. And if you tap into the profits before you’ve cleared your own hurdle, you’ll have to pay taxes on the profits you tapped into plus an extra 10% as an early withdrawal penalty. (This 10% penalty before 59½ is a common feature of account types that are geared towards retirement.)

The other major strings attached to a Roth IRA are:

• Contributions don’t lower your tax bill for the year. (Unless your income is low enough to qualify for the Saver’s Credit.)
• You can only contribute so much per year. In 2018, the limit is $5500, plus an additional $1000 if you’re turning 50 this year or have already passed 50.
• You can’t contribute more than your work/business income each year, unless you’re married and your spouse makes enough work/business income to cover your contributions in addition to their own. This exception allowed my wife to contribute to her Roth IRA even in years when I was the breadwinner and she the homemaker. (This exception only applies if the spouses file their taxes jointly.)
• It’s possible to make “too much” money to contribute. How much is too much depends on how you file your taxes. Consult a tax professional or check here.
• The deadline to contribute each year is April 15 of the following year. Thus, for example, you have until April 15 2019 to make a contribution for this year. If you miss the deadline, you forfeit the opportunity to contribute for that year.

I should also point out that my wife and I have named each other the sole primary beneficiary on our respective Roth IRAs. This ensures that as long as at least one of us is alive, all of our Roth IRAs will keep all of their tax advantages. (If a Roth IRA passes to a non-spouse beneficiary, the money stays tax-free, but it doesn’t get to enjoy that protection forever. The account eventually has to be closed, although it doesn’t have to be all at once. For more info, consult a tax professional.)

Now besides the Roth IRA, there are two other types of tax-free account. One is a designated Roth account inside a 401(k), 403(b), 457(b), or the TSP (Thrift Savings Plan) for federal employees; the other is a permanent life insurance policy. Both of these vehicles are advantageous over a Roth IRA in that (a) your contribution limit each year is potentially much higher and (b) your ability to contribute isn’t adversely affected by your making “too much” money. And in the case of permanent life insurance, there’s also no tax penalty for pulling money out “too soon” (before you turn 59½ or before 5 years have passed since your first contribution).

But to get a designated Roth account, you need to either (a) work for an employer who offers a retirement plan that gives access to such accounts (not all retirement plans do), or (b) be self-employed and set up your own personal 401(k) with a designated Roth account. And to get a permanent life insurance policy, the insurer needs to be willing to bet that you’re going to live a nice long time (it is life insurance, after all). Furthermore, if you want to be able to enjoy the policy’s tax-free benefits, you have to make a lifelong commitment. If you cancel the policy or lose it because you failed to keep the ongoing life insurance expenses covered, the tax-free benefits disappear. (Some policies require you to make regular out-of-pocket payments your whole life, while others give you the opportunity to manage your investments within the policy so that they cover the expenses for you.)

I’m not telling you which type of tax-free account to get. It really depends on you and your situation. I chose to focus on the Roth IRA here because it’s the easiest to set up. But I’m happy to report that you could have all three types if you wanted! Contributions to one don’t affect how much you’re allowed to contribute to the other two.