Cash Reserves

Quiz!

When can you withdraw Roth IRA contributions without penalties?

1. When your Required Minimum Distributions (RMD) start: age 72 or older
2. Age 59½
3. 5 years after the contribution
4. 5 years after opening the Roth IRA
5. Immediately
6. Never

A Hidden Benefit of Roth IRAs

There are plenty of articles that talk about tax benefits of Roth IRAs. But, there is a benefit that can shine if used correctly:

1. You can withdraw the contributions (as opposed to earnings) right away without penalties!
2. You can also withdraw amounts that were converted to Roth IRA penalty-free, 5 years after each converted amount.

How can you use this benefit?

1. As soon as you start earning income (whether you are 25 or 10 years old), put the maximum allowed into a Roth IRA, unless you are certain to spend it soon. If you don’t have enough low-volatility reserves outside the Roth IRA, keep building them inside the Roth IRA.
2. If your income is too high, you can contribute to a Traditional IRA and immediately convert to Roth IRA, regardless of your income (nicknamed Backdoor Roth).
3. If you have enough reserves (in taxable accounts + Roth IRAs), maximize your employer retirement contributions (e.g. 401k or 403b), putting the employee contributions into Roth (e.g. Roth 401k), if possible.
4. The point above applies also if you are self-employed – you can maximize contributions to a Solo-401k, adding large employer contributions.
5. Whenever you switch jobs, you can rollover your 401k or 403b to a [Roth] IRA, and convert the IRA to Roth IRA. For large balances, you can spread the conversion over multiple years, emphasizing years with low taxable income, to lower the effective income tax rate. Once in Roth IRA, it becomes available for withdrawal penalty free after 5 years.
6. Count your Roth IRA contributions (not earnings) immediately & conversions (after 5 years) as part of your cash reserves, by calculating a sustainable withdrawal rate from them (typically 3%-4% for stock portfolios). For example, if you contributed a total of $100,000, you can count $3,000 or $4,000 of it as part of your cash reserves.
7. There are a number of ways to access your Roth IRA earnings, without penalties. They are covered in many articles, but I will point out an important one: substantially equal periodic payments. It requires a commitment to withdrawals for 5 years, and at least until age 59½, so wait to use it after depleting all other sources (all money outside retirement accounts + all principal contributions to the Roth IRA). The nice thing is that it creates lifelong income, similar to the manufactured approach I described for the Roth IRA contribution right above.

Quiz Answer:

When can you withdraw Roth IRA contributions without penalties?

1. When your Required Minimum Distributions (RMD) start: age 72 or older
2. Age 59½
3. 5 years after the contribution
4. 5 years after opening the Roth IRA
5. Immediately [The Correct Answer]
6. Never

Explanation: You can withdraw Roth IRA contributions (not the earnings on them) without penalties right after making the contribution, with no delay, regardless of your age. See this month’s article for how to use this to your benefit.