Opening an Individual Retirement Account is an excellent step in retirement planning. However, you will be faced with a choice: will you choose a Roth or a traditional IRA? Your contributions to either count towards the total annual limit for both account types, so your choice is crucial. A Roth IRA has many advantages for your tax situation. Here are the top benefits of Roth IRAs that you might not know about. You can also work with a financial advisor to help you find the right retirement account for your situation.
What is a Roth IRA?
A Roth IRA is an individual retirement account that uses money taxed by the government. For example, suppose you receive a $2,000 paycheck from your employer every two weeks. This money comes back to you after taxes have been deducted. You deposit $200 from each paycheck into your Roth IRA. When you retire, you won’t pay taxes on your Roth IRA distributions because you paid them while working. This scenario is the opposite of a traditional IRA, which gives you an income tax cut while you work and incurs taxes in retirement.
Key Benefits of Roth IRAs
Roth IRAs are distinct from traditional IRAs and can improve your tax situation in the following ways:
Tax-efficient returns
Retirement accounts generally incur income or capital gains taxes when their investments earn money. However, you won’t owe taxes when your Roth IRA grows. This aspect increases your retirement income and minimizes account fees.
Withdrawal flexibility
Roth IRAs also allow you to withdraw money before retirement. Specifically, you can withdraw contributions at any age without incurring a penalty. However, you must have had the account for at least five years before accessing your contributions without paying a penalty. Similarly, you will draw a financial penalty if you withdraw before age 59.5.
That said, there are several exceptions that allow you to circumvent the penalties. For example, first-time home buyers can withdraw $10,000 from the account at any time to help with the down payment. Plus, you can cover eligible expenses for education, medical expenses, adoption or birth. Finally, your funds are accessible in the event of death or disability.
Remember that the five-year rule applies after age 59.5. So, withdrawals after that age from an account you’ve held for less than five years will incur income tax. However, once you pass the generation and five-year milestones, your funds are fully accessible without taxes or fees. So you can withdraw as much money as you want per year without changing your tax situation.
No RMD
Required Minimum Distribution (RMD) laws mandate mandatory withdrawals from many types of retirement accounts. In short, the laws require retirees to withdraw money from their retirement account at age 72, even if they don’t need to. Fortunately, Roth IRAs are exempt from this rule, meaning your funds will stay in your account, earning returns until you need a distribution.
No tax burden for beneficiaries
Your Roth IRA funds are also tax-free if you die and leave your account to your named beneficiaries. Additionally, the IRS allows penalty-free withdrawals from inherited IRAs for beneficiaries under age 59.5. However, RMD rules still apply, which means the loved one receiving the IRA must eventually withdraw all the money from the account.
Reduced income taxes
Because Roth IRA distributions have no tax implications, they are useful if you expect substantial income during retirement. For example, if you earn less than $89,450 and file your taxes jointly with your spouse, you will remain in the 12% tax bracket. Doing it with a Roth IRA means paying that low rate while you work. Then you’ll receive tax-free distributions in retirement, helping you stay in the 10% tax bracket, the lowest possible rate you can get.
Coupling with other account types
Your Roth IRA provides tax diversification when you contribute to another retirement account. For example, if your employer offers a 401(k) plan, you can make pre-tax contributions and after-tax contributions to your Roth IRA. This option spreads your tax burden over your working years and retirement, reducing financial strain at both stages of life.
Disadvantages of a Roth IRA
Although Roth IRAs offer a multitude of advantages, they have several disadvantages:
Income level prevents accessibility
IRS regulations prohibit Roth IRAs for those whose Modified Adjusted Gross Income (MAGI) is too high. Specifically, if you’re married and filing jointly, you can contribute to a Roth IRA with a MAGI of $218,000 or less. A MAGI below $228,000 reduces the amount you can contribute, while an income above that limit means you can’t contribute a single dollar to a Roth IRA.
Filing as single or as head of household brings similar limitations. Specifically, the income limit for these tax situations is $138,000. Those with a MAGI between $138,000 and $153,000 can contribute less to a Roth IRA while exceeding the upper limit prevents you from contributing. Conversely, traditional IRAs have no income limit, which means anyone can contribute.
Limited deposit limits
Another disadvantage of IRAs is their low annual contribution limit. Specifically, you can contribute $6,500 to the account in 2023. If you are 50 or older, you can contribute $7,500. Therefore, you may need to open an additional retirement account, such as a 401(k) or 403(b), to save enough for your retirement.
No pre-tax options
A Roth IRA cannot use pretax dollars. Therefore, you cannot reduce your income taxes with a Roth IRA during your working years. This aspect can harm your tax situation if you expect your income to be significantly higher in your career than in retirement. For example, if you earn $95,000 this year, you’ll pay 22% of your income before depositing it into your Roth IRA. On the other hand, putting pre-tax dollars into a traditional IRA and planning an annual retirement income of $44,000 means paying a 12% tax rate on your contributions.
Conversion limits
Because income can limit your ability to contribute to a Roth IRA, conversions are a popular option for high-income earners to get this type of account. Specifically, you can open a traditional IRA, contribute to it, and then convert it to a Roth IRA. This requires you to pay the income taxes due on the contributions. Also, the downside here is that you can’t switch back to a traditional IRA once it becomes a Roth. It is therefore best to only perform a conversion with a detailed plan in place.
Alternative retirement accounts
Since your tax situation or income level may make the Roth IRA inferior or unsustainable, you may consider other retirement savings options. Consider the following:
-
Traditional IRA: A traditional IRA has no income limit, which means that your annual payments will not prevent you from contributing to the account. However, the annual contribution limit of $6,500 still applies.
-
Brokerage account: You can also open a taxable brokerage account if you want greater accessibility to your funds, the trade-off being capital gains taxes on your returns.
-
Employer-sponsored plans: Accounts such as 401(k) and 403(b) accounts are great options. You can receive matching contributions from your employer and contribute up to $22,500 per year. Additionally, people over 50 can deposit an additional $7,500.
The essential
Roth IRAs offer unique tax advantages and withdrawal options for account holders. Specifically, you will not pay income tax in retirement with the account and can withdraw funds earlier from the amount of your contribution. Plus, they’re available to anyone under the income limit, meaning you’re not dependent on one employer or job type to contribute to the account.
That said, the biggest tax benefit of the Roth IRA may also be its downfall. If you’d rather save money before taxes and pay taxes in retirement, it’s best to contribute to a traditional IRA. Plus, the low annual contribution limit may force you to look elsewhere to save money for retirement. Therefore, evaluating your retirement plan and tax situation is necessary to know if a Roth IRA makes sense.
Tips for having a Roth IRA
-
It can be difficult to understand whether pre- or after-tax pension contributions are optimal. Your financial situation is unique, and you’ll need to consider every aspect of your situation to understand if a Roth IRA is best for you. Fortunately, a financial advisor can help you understand your options. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three approved financial advisors who serve your area, and you can interview your advisor for free to decide which one is right for you. If you’re ready to find an advisor who can help you reach your financial goalsstart now.
-
As mentioned, the Roth IRA is just one of many retirement plans available. You can read more about the best types of retirement plans to choose one that’s right for you.
Photo credit: ©iStock.com/SDI Productions, ©iStock.com/jygallery, ©iStock.com/Spotmatik
The post 6 Key Benefits of Roth IRAs appeared first on SmartAsset Blog.