Savings - Retirement Planning - Investing - Tax Planning - Tax-Favored Accounts - Coins - Tree

Why You Should Consider Investing in a Roth IRA

Intro

A Roth IRA is funded with after-tax dollars, but distributions are tax-free in retirement. Everyone knows that, but Roth IRAs have special properties and use cases that rarely get mentioned.

In this episode, we explain what the general and special benefits of a Roth IRA are, as well as under what circumstances you may want to invest in a Roth IRA. Some of the items discussed include:

  1. Tax-free and penalty-free distributions prior to retirement
  2. Protecting your assets from taxes, inflation, and government!
  3. Required minimum distributions (RMD)

Podcast

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Hey everybody, welcome back to the Bigger Insights Finance podcast where we’ll help

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you live a life you don’t need a vacation from.

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Let’s talk about why you should consider investing in a Roth IRA.

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When you ask almost anyone whether or why you should have a Roth IRA, they pretty much always

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say the same thing.

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They say something like, “Well, do you expect your income to be higher or lower in retirement?”

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And this really grinds our gears for a number of reasons.

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1. There are many other considerations when weighing a Roth versus a traditional IRA.

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Roths [IRAs*] have special attributes that other accounts do not.

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And 2. Why would anyone plan on their income going down over time?

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We do acknowledge that there are ways to decrease your income on paper while increasing

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your wealth.

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But this isn’t what people are talking about when they ask this question.

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They’re assuming that you’re going to retire and draw down your assets hoping that you

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die before you run out of assets.

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This philosophy on retirement planning really needs to die because it’s incredibly stupid.

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Why would anybody want to do that?

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Your goal should be financial freedom, not to die before your 401(k) goes to zero.

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With that rant out of the way, let’s go over some quick caveats.

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1. We are not CPAs, tax attorneys, enrolled agents, or other tax professionals,

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and nothing in our podcast is tax advice.

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IRA rules can get pretty complicated, so we highly encourage you to consult your tax advisor

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before making any changes to your tax situation.

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2. Some of the items discussed may not be applicable in your jurisdiction.

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For example, income tax and asset protection rules may vary from state to state.

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3. Laws change.

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By the time you hear this information, changes in the law may have already made this information

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obsolete.

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However, this information is believed to be accurate as of the time this recording on

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May 31, 2023.

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4. And the final caveat is that some of the items discussed in this episode may not be applicable

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to your specific situation.

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For example, we’re going to be talking about withdrawing Roth IRA contributions tax and

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penalty-free. But like anything else, just because you can, that doesn’t mean that you

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should.

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All right, now let’s go over some general benefits of an IRA.

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After that, we’re going to detail advantages that are specific to Roth IRAs, then we’ll

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bring it all together and explain under what circumstances a Roth IRA may be right for

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you.

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Like other tax-favored accounts, you can self-direct a Roth IRA. Which may be worth considering

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depending on your situation, because by law, an IRA can invest in almost anything.

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There are only a few things like collectibles, alcohol, insurance, and most precious metals

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products that you can’t invest in, but you can invest your IRA in stocks, bonds, real

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estate, commodities, Bitcoin, and specific precious metals products.

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IRAs are also nice because dividends and capital gains are generally tax-free.

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Now that might depend on the jurisdiction that you live in and what type of assets you’re

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invested in.

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Some investments are subject to unrelated business income tax (UBIT) and unrelated debt-financed

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income tax (UDFI).

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But that’s beyond the scope of this episode and honestly doesn’t apply to most IRA investors.

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We may end up talking about that in more detail in a future episode.

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IRAs also offer some asset protection, but this varies state by state.

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If you have an IRA and a 401(k), you’ll probably find that you have more investment options

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with your IRA.

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And this is because 401(k)s usually provide a very limited number of mutual funds for you

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to invest in, whereas IRAs at a brokerage firm will typically allow you to invest in

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almost any security that trades on their platform.

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This can be very important because there are a lot of bad 401(k)s out there.

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I had a 401(k) once that only had somewhere between like 50 and 100 mutual funds, but

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none of them provided any exposure to commodities, precious metals, long-term treasuries, CDs,

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and there were only like one or two REIT funds and I didn’t like either of them.

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The last general advantage we’re going to discuss is that retirement account assets

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are generally excluded from student aid calculations.

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This makes these great vehicles for working kids to stash some income without losing out

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on a significant amount of student aid.

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All right, now let’s get into the good stuff.

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What unique advantages do Roth IRAs provide?

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First of all, this might be below some people’s minds, but you can generally withdraw your

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basis at any time, tax-free and penalty-free.

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There are some rules around that which we’re not going to get into in* this episode, such

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as the five-year rule for Roth Conversions, but in general, you can withdraw any or all

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of your basis tax and penalty-free anytime, even if you’re not in your retirement years.

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Now, the tax-free portion of that shouldn’t surprise anyone because those contributions

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have already been taxed, but the penalty-free aspect is specific to Roth IRAs.

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In other tax-favored accounts, you usually pay about a 10-20% penalty for withdrawing

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funds without a valid reason.

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This makes Roth IRAs very powerful because you can use them to stuff some cash away for

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a rainy day or some future opportunity, then pull it back out if or when you need to.

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Another advantage that’s specific to Roth IRAs is that they are not subject to Required

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Minimum Distributions (RMD), whereas traditional IRAs and both 401(k) types are.

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For this reason, when you retire, it may make sense to roll a Roth 401(k) over to a Roth IRA

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because the Roth 401(k) is subject to Required Minimum Distributions.

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Why you might be wondering?

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We have no idea, but that’s just the way she goes.

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When you’re young, you may not think that this is a big deal, but it will be when you

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retire.

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Required Minimum Distributions present a number of headaches for retirees.

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One, they may force you to sell assets at a bad time or sell illiquid assets.

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So for example, your income might be particularly high in a certain year or they’ve temporarily

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declined in value, but in either case, you may not want to sell them, but the government

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is going to force you to.

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And two, Required Minimum Distributions may make it difficult to leave tax-favored assets

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to your heirs.

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The third advantage that we want to talk about is that a Roth IRA allows you to effectively

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contribute more than you can with a traditional IRA.

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Now technically, this does apply to 401(k)s as well, but those have much higher contribution

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limits than IRAs do.

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So this advantage is a little bit more pertinent to IRAs.

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Roth and traditional IRAs have the same contribution limits, but what’s interesting about that

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is those contributions have different values because Roth contributions are after-tax.

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So in other words, $6,500 contributed to your Roth IRA is more valuable than $6,500 in a

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traditional IRA because it has already been taxed.

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That $6,500 in your Roth IRA represents something closer to about $9,300 that you earned and

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paid taxes on.

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This advantage is more useful when you’re maxing out your IRA contributions.

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The fourth advantage is that a Roth Conversion can save you significantly on your taxes if

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you experience years of lower income.

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Keep in mind that you don’t have to do a Roth Conversion all at once.

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If you have a Roth and a traditional 401(k), you might have to do that all at once because

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many 401(k) plans don’t allow in-plan conversions and they also don’t allow partial conversions,

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but that’s not an issue with your IRA.

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So if your income is a little bit lower or if you expect it to go up significantly in

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future years, you can do a full or a partial Roth Conversion with your IRA.

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This might be appropriate if you get laid off, you start a business, or if your income fluctuates

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quite a bit with the ebbs and flows of the economy, so take advantage of this when the

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situation calls for it.

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Depending on the circumstances, it can make sense to even do a small amount like $1,000.

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So basically what we suggest that our clients do is contribute to traditional accounts when

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their income is high, then slowly convert those contributions over to Roth over time

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when their income fluctuates to the downside.

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If you would like this kind of help as well, consider becoming a Bigger Insights client.

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If you’re interested, go to our website, BiggerInsights.com, and fill out the short

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form at the bottom of the page so we can schedule your initial consultation.

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The final advantage that we’re going to highlight is that we’re somewhat bearish on other

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tax-favored accounts due to their lack of flexibility and uncertainty as to what politicians will

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do to the rules moving forward.

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This is where Roth IRAs shine.

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Because your contributions have already been taxed and there are no Required Minimum Distributions,

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if the rules change against you, you’re probably going to suffer less with a Roth IRA than

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other accounts.

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Just imagine for a moment that our debt problems come home to roost, so politicians do something

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like raise the retirement age, make Required Minimum Distribution rules more stringent,

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or raise tax rates, you’re going to be better off in a Roth IRA because these changes won’t

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affect you as much.

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Now let’s bring it all together and talk about what this all means.

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We like to do this because we acknowledge that taxes are boring, and you may not realize

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how some of these things that we’ve talked about might affect you.

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But to help summarize this, let’s go over seven scenarios that may make a Roth IRA advantageous.

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1. Roth IRAs are great for working kids.

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Fidelity and other custodians have Roth IRAs for kids.

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If your child has earned income, stuffing that money into a Roth IRA is probably a good

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idea. Because if their income is low enough, that income may never be taxed a single penny,

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because it won’t be taxed when it’s contributed to the Roth IRA, it won’t be taxed as it grows,

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and it won’t be taxed when they pull it out in retirement.

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If you own a business, you can and should consider hiring your children, which will

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give them some income that they can put into a Roth IRA, and you can deduct that as a business

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expense.

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2. Roth IRAs are great for younger people in general, not just kids, assuming that their

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income will grow over time.

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Young adults should be mindful of the income limit to contribute directly to a Roth IRA.

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This limit is fairly low.

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I think it’s somewhere in the ballpark of $140,000, so you don’t want to put off contributing

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to a Roth IRA until someday you find out that you make too much money to contribute to one

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directly.

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3. A Roth IRA can be very helpful when your income drops to an unusually low level,

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like when you lose your job or you start a business.

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4. Roth IRAs are great for retirement planning. Being able to withdraw in retirement tax-free,

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and not being subject to Required Minimum Distributions, makes the Roth IRA a very powerful

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retirement planning tool.

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5. People who want to start a business someday, or otherwise may need to come up with

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large sums of money, may find Roth IRAs very advantageous.

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Putting your money in a Roth IRA is great because it can grow tax-free until you need the money

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for other purposes.

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So I like rental real estate, for example.

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I mean, not at these prices, but in theory I like it.

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If a good opportunity does come up, I may either buy a property in my Roth IRA or withdraw

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my basis and use that money to buy the property on the taxable side of my portfolio.

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6. A Roth IRA can be helpful for real estate investors, at least relative to a traditional

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IRA.

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So, for example, if you have an apartment building in a Roth 401(k) or a traditional IRA,

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you would need to take* Required Minimum Distributions, which would be a problem.

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I mean, how do you sell a portion of that apartment to satisfy that requirement?

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In the case of the Roth 401(k), it may make sense to roll that over to a Roth IRA in retirement

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to avoid those Required Minimum Distributions.

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7. The seventh and final situation when you may want a Roth IRA is basically if you have concerns

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about future policy.

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U.S. federal debt is completely out of control.

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That’s going to have to be paid back with taxes and inflation, both of which a Roth

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IRA can help protect you from.

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On the tax front, you’ve already paid your taxes. And on the inflation front, you can

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invest in assets that maintain their purchasing power tax-free.

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Now, that’s an important point because you can obviously invest in those assets in your

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taxable accounts as well, but in an inflationary environment, you will have to pay capital gains

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taxes on phantom gains because inflation has artificially raised the value of those assets,

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but that’s not a concern in your IRA.

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All right, so to wrap this up, we have some final thoughts for you to consider.

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1. First, high-income earners can still participate in a Roth IRA with backdoor contributions.

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We may discuss this in a future episode, but just keep in mind that this may be an option

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for you if your income is too high to be able to contribute to a Roth IRA directly.

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Another important thing to note is that we do like Roth IRAs, but we encourage our clients,

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especially our younger clients, to not overdo them because we do have concerns about future

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policy changes.

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If we get into a major fiscal crisis, for example, it would be fairly easy for politicians

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to hose 401(k) and IRA holders. But again, we still think that you’d be better off in a

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Roth IRA than some of the other accounts. But don’t let that discourage you from participating.

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If a Roth IRA presents a good opportunity for you, take advantage of it.

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And finally, try to ignore what average people and financial gurus tell you about tax-favored

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accounts and do your own research.

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The rules for these accounts can be quite complicated because there are rules for contributions,

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distributions, taxes, succession, asset protection, dividing assets in the event of a divorce,

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prohibited transactions, and so on.

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I’m not just blowing smoke when I say that.

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I’ve been taking notes on these accounts for years, and so far I’ve written about 40 pages

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of notes. So trust me when I say that these things are complicated.

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We would also encourage you to take good notes as you do your research because there’s no

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way that you’ll be able to remember all of this information.

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All right, that’s it for this episode.

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Super exciting stuff we know.

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If you’d like more help with this, please reach out to us to schedule your initial

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