Hi, I’m Kevin McKee from Thousandaire.com and I’m interrupting your regularly scheduled programming today to give you my biggest financial pet peeve. Robert and I are swapping posts today, so you can head over to my site to read Robert’s pet peeve about The Biggest 401(k) Mistakes You Can Make.
Have you ever heard someone mouthing off about something like they are an expert, but in reality you know a lot about what they are talking about and you are absolutely certain they are dead wrong? Like when someone insists David Lee Roth Van Halen is better than Sammy Hagar Van Halen. Sorry, but that’s ridiculous.
Even worse than when someone has a bad musical opinion, listening to someone give bad personal finance information is very uncomfortable because then it puts you in a dilemma. Should you tell them they are wrong (to which they will probably insist they aren’t) and turn it into an awkward situation, or do you just let it go, knowing full well they will be spreading bad information to other people?
Here are a few examples of statements I’ve heard in the past that are simply not true:
• I don’t use retirement accounts because I don’t want my money trapped until I’m 60
• I’m gonna buy a house in two years, so I opened a Roth IRA today because I can use all that money for my first house
• You can only use $10,000 of your Roth for your first house
These are just a few examples of how people don’t understand a Roth IRA. If you don’t want to be one of those frustrating, uninformed people, here are the basics of a Roth IRA.
You Can Access Contributions at Any Time
If I open a Roth IRA today and put in $5,000, then I can take that $5,000 out tomorrow. Or next week. Or next year. Or 16 years from now. It doesn’t matter. That money has already been taxed and you can do whatever you want with it. The only situation where you can’t pull out the money you put in is if you’ve lost money on your investments. If you put in $5,000 and pick bad investments and lose $1,000, then you can only pull out the $4,000 you have left. It is also important to note that you cannot take out capital gains (positive investment returns) at any time. If you put in $5,000 and you pick good investments and make $1,000, you can’t pull out all $6,000. You can pull out your $5,000 in contributions, but the $1,000 has to stay in unless it comes out as a qualified distribution.
You Can Only Take Qualified Distributions After the Account Has Been Open and Funded for Five Years
You can take qualified distributions (of capital gains) out of your Roth IRA if you are 59 and 1/2 or older, for the purchase of your first house, if you are disabled, or if you die and the money is distributed to your beneficiaries. Money is not taxed or penalized as long as the account has been open and funded for five years. A lot of people ignore this rule and just think they can take qualified distributions whenever they want. If you are 90 years old when you first open a Roth IRA, you will still have to wait five years to take out capital gains, despite the fact that you are obviously at a retirement age.
So let’s review those first three statements:
• I don’t use retirement accounts because I don’t want my money trapped until I’m 60 (wrong: you can take out contributions at any time, and you can get qualified distributions early for capital gains)
• I’m gonna buy a house in two years, so I opened a Roth IRA today because I can use all that money for my first house (wrong: you can take out your contributions, but any capital gains would not be qualified distributions because the account wasn’t open for five years)
• You can only use $10,000 of your Roth for your first house (wrong: You can take out 100% of your contributions, plus $10,000 of your capital gains if the account has been funded for five years. If you had $50,000 in contributions and $30,000 in capital gains, you could take out all of the $50,000 in contributions plus $10,000 of the gains, for a total of $60,000 towards your first house)
If you still don’t get it, here is a little video I made that explains the difference between Traditional and Roth IRAs, and how you can use them to your advantage.
Understanding how to use investment vehicles to avoid paying taxes can save you thousands of dollars if you know what you’re talking about. However, if you don’t know what you’re talking about, please shut up about it.
MJ says
Good info! Kinda wish it wasn’t written in such a condescending way. When you overhear incorrect advice, you should definitely step in, but climb off your high horse before you try to explain it. Your corrections will probably be met with them insisting they are right, but at least you tried.
Jake P. says
It is angering when someone pretends to know everything about something they actually know nothing about it. It’s especially bad if they are stating the exact opposite of what something is. I have a finance blog and I know quite a lot about finance, but if I don’t understand something, I won’t blog about it. As far as the Roth IRA goes, I prefer to invest my money through a broker where I can make similar investments but have constant access to gains. Besides, the type if investing I do is shorter term and requires constant shifting of capital. We all have our own styles though!
Kevin @ Thousandaire.com says
@MJ – This was a “pet peeve” themed post, which is why it had the tone it did. If you watch the video, I give a much “happier” explanation
@Jake P. – If you understand a Roth IRA and don’t want to use one, more power to you. I like when people know what they are talking about and make informed decisions. It’s definitely not for everyone.
Robert says
Kevin, thanks for the great post! I hate it when people think they know and they don’t. The sad part is that these are the people who hurt themselves, don’t save, and the rest of us end up supporting them!
Eliza from Happy Simple Living says
Great article, Kevin. I was planning to open a Roth IRA this year before 4/15, and your article has given me the extra impetus I needed to do my homework and make sure I understand all the ramifications.
krantcents says
You mentioned, in my opinion, one of the most important features of a Roth which is using it for a down payment for a house. There are limitations, but still a pretty good deal
Barb Friedberg says
Very good explanation; clear and concise. It is difficult to keep track of all of the options available for retirement investing as well as their individual requirements.
Jacob @ My Personal Finance Journey says
It’s also important to remember that while Roth IRA funds have already been taxed, I believe withdrawals will be hit with the 10% early withdrawal penalty, if you pull them out before the allowed time.
JoeTaxpayer says
Withdrawals on ‘earnings,’ yes. Not on the principal you deposited. Which is part of what makes Roth a great choice for those who might need to withdraw early, it’s not quite 100% locked up.
Kevin @ Thousandaire.com says
@Eliza – Definitely open it before 4/15. It means your open date will actually be 2010. Just make sure you make a 2010 contribution. If you don’t specify that with your broker, it will probably default to 2011 and you won’t get credit for 2010.
@krantcents – Yep, $10,000 of gains plus all contributions for your first house (first = haven’t owned a house in the last two years). All of that is tax and penalty free too!
@Barb – Thanks Barb. I feel like if people only understand one retirement investing option, it should be the Roth IRA
@ Jacob – The only time you are hit with an early withdrawal penalty is if you are taking out capital gains for an un-qualified distribution. You can always take out your contributions tax and penalty free.
retirebyforty says
Good explanation Kevin. I admit, I was one of those people who is not completely clear about Roth IRA. I just put money in and don’t plan to withdraw it anytime soon so I didn’t research the distribution much.
thx!
Jason says
That video was great! I already knew everything you covered, but the way you did it seems like anybody could be an expert after watching you.