Roth IRA Misconceptions – A Roth IRA Isn’t That Hard To Understand

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.