Don’t think a Roth IRA is just for rich people. There are nine reasons everyone needs to open a Roth retirement account.
Taking advantage of tax benefits in retirement accounts should be the easiest investing decision you ever make. The instant tax savings on 401(k) plans and Individual Retirement Accounts (IRA) represent an instant return on your money and decades of tax-free growth.
One type of retirement account remains misunderstood among investors. It doesn’t offer the instant tax savings of a 401(k) but may offer something even better.
The Bureau of Labor Statistics (BLS) reports spending the average American over 65 pays about 8% in taxes on an income of $46,627 annually. That tax bite is lower than the average for all consumers but still sends almost one in every ten dollars to Uncle Sam.
It's difficult enough to lock in retirement income, wouldn’t it be nice if you could protect it from taxes as well?
That’s the power of a Roth IRA account.
While many investors think this form of retirement plan is only appropriate for the wealthy, the fact is there are quite a few reasons everyone should open a Roth retirement account.
How is a Roth IRA Different from Other Retirement Accounts?
You deduct your contributions into most retirement accounts from your income in the year you make them. This lowers your taxes for the current year and investments grow tax-free until you withdraw them during retirement.
When you withdraw from your retirement accounts, you pay ordinary income taxes on the amount. That can push some investors into higher tax brackets, especially those with pension or other investments.
Roth IRA accounts are funded with after-tax dollars. You don’t take the contribution off your income when you make it and don’t get the immediate deduction. Your retirement investments grow tax-free in the account and you can withdraw them tax-free in retirement.
That’s the power of a Roth IRA, tax-free money in retirement, but there are other reasons to open a Roth account.
About that Tax-Free Money from Roth IRA Investing
We’ll get to the other reasons to open a Roth retirement account but let’s talk about those tax-free earnings one more time.
As long as you are over the age of 59 ½ and have had the money in your account for five-years, you can withdraw principal and earnings tax-free from a Roth account. There are also early withdrawal exceptions for disabled individuals or for those buying their first home.
One of the first things I hear from investors when talking about opening a Roth IRA is the expectation of a lower tax rate during retirement. The way of thinking is that investors need a bigger tax break today, provided by other types of retirement accounts, rather than saving taxes in the uncertain future.
The fact that the future is so uncertain makes a Roth IRA so necessary. You may expect your retirement tax rate to be lower but you really can’t know. Besides the potential for a higher tax rate in the future, a Roth IRA helps you better manage your tax rate. You can take more tax-free Roth money during years of higher income and sell fewer taxable investments.
No Minimum Required Distributions with a Roth IRA
One of the biggest problems with other retirement accounts is what’s called minimum required distributions (RMDs) during retirement. Once you reach 70 ½, you are required to take a certain amount out of a traditional IRA each year. It’s based on your age and how much you have in the account so could potentially force you well into the next tax bracket.
Worse still, fail to calculate your RMD or take enough out and you’ll pay a penalty of 50% of the amount not taken.
Money in your Roth IRA plan can sit there for as long as you like. You never have to touch it if you choose and it can actually be a great way to pass money on to heirs.
Leave tax-free money to heirs.
Roth IRA plans may be the best estate planning tool available.
Required distributions from inherited IRAs and other retirement accounts can be just as treacherous for heirs as they are for retirees. Retirement account money inherited in an estate may come during peak earning years when taxes are already high and can mean thousands lost from the estate.
While your heirs will have to take required distributions from an inherited Roth IRA, they won’t have to pay income taxes on the amount. Since you never have to take distributions from your Roth account, it’s a great way to allocate tax-free earnings to your family.
Tax flexibility in retirement.
I eluded to this Roth IRA reason earlier. Roth IRAs give you tax flexibility during retirement.
If you are only relying on 401(k) or traditional IRA assets, you’ll be at the mercy of required distributions and other income for how much taxes you pay each year. If you receive a large chunk of income in a particular year, it might not only force you into a higher tax bracket but can jeopardize other income-based retirement benefits.
Being able to take more or less from your Roth account to lower your tax burden in specific years is a benefit most investors overlook.
Help reduce or even avoid the Medicare surtax.
One of those important income-based retirement ideas you’ll want to watch is the Medicare surtax charged on income over $250,000 for joint filers.
Roth IRA money does not count against your modified adjusted gross income (MAGI) so doesn’t affect your limit for the Medicare surtax. Income from traditional IRAs and other retirement accounts is counted in your MAGI and could push you above income limits.
The surtax is 0.9% which could cost hundreds of dollars a year for higher-income retirees.
Roth IRAs as a hedge against future tax hikes.
The current administration in Washington has promised lower tax rates…but how many times have we heard that before? Whether we get lower income taxes now, there is a very good chance that rates will have to go back up in the future.
The U.S. is more than $19 trillion in debt and programs like social security and Medicare are nearly insolvent. Unless the government wants to default on its debt, not really an option, then it will likely need to raise money from taxes.
I’m not a policy specialist or trying to make a political statement. The fact is we can’t know what tax rates will be in the future, whether they’ll increase and by how much. Having money in a Roth IRA helps you to minimize that uncertainty with tax-free income.
Use your Roth contributions at any time.
Another challenge for retirement savers is the fact that money in traditional IRAs and other accounts cannot be withdrawn until 59 ½ without paying a steep penalty.
This isn’t the case with a Roth IRA. You are allowed to withdraw money contributed to a Roth IRA whenever you like, at any age and without a penalty. The earnings on your contributed money are subject to taxes and a penalty if withdrawn early but the money you put in is yours to use.
I see too many investors come up against an unexpected expense they can’t cover with income or savings. They’re forced to withdraw money from a traditional IRA, paying taxes and the 10% penalty.
Those taxes and penalties could mean having to withdraw a huge chunk out of traditional retirement accounts. For someone in the 35% tax bracket and needing $5,000 to cover an emergency, you would need to withdraw more than $8,500 to have the money left over after taxes and the penalty.
That’s more than $3,500 of your money lost.
With a Roth IRA, you could take that money out without losing a dime.
If you’re older, you can continue to contribute to a Roth IRA as long as you work.
Because of the required distributions, you’re not able to continue contributing to many types of retirement accounts after 70 ½ years of age.
Not so with a Roth IRA. As long as you have taxable income from a paycheck or 1099 income for work, you can contribute to a Roth IRA, at any age.
If you're young, your income is likely to rise.
The biggest benefits to opening a Roth IRA may come to those that know least about it. Younger investors typically have lower tax rates compared to where they’ll be in retirement. That makes paying taxes now and getting tax-free income even more appealing.
Money you invest in a Roth IRA will also have more time to grow tax-free, helping to avoid the retirement savings nightmare that most Americans face.
Using the Backdoor to Open a Roth IRA
Contributions to a Roth IRA are limited to those joint filers making less than $196,000 (2017) or less than $133,000 for single filers.
This may be where some of the misconceptions about Roth IRAs come. Investors reason that because the government limits contributions for the wealthy, the accounts must be especially beneficial to that group of tax payers.
The fact is that a Roth IRA is just as advantageous, and maybe more so, for lower-income savers as it is for the wealthy.
If your income is over the IRS limits, you can still open a Roth IRA by converting existing retirement accounts. The government allows you to convert other retirement accounts into a Roth account regardless of income as long as you pay income taxes on the amount.
That means you’ll need to watch your current year’s income to make sure the Roth conversion doesn’t burden you especially hard with increased taxes. You’ll also want to pay the taxes out of savings rather than the IRA money or face a penalty on the amount.
Final Thoughts on Benefits of Opening a Roth IRA
Below is a quick review of the three most common retirement accounts, as well as advantages and limits of each. Investing in all three types of accounts is one of my favorite ways to make your investments go further.
A Roth IRA is an important tax tool and retirement savings vehicle for any type of saver, regardless of age or income. Being able to withdraw tax-free income in retirement will give you the confidence that you’ll be able to meet your financial goals through multiple sources of income. Don’t overlook these nine reasons to open a Roth IRA and enjoy the financial flexibility and the retirement you deserve.
