Individual retirement accounts (IRAs) provide investors with an amazing opportunity to save on taxes. By investing in an IRA, you are paying your future self while also lowering your income tax bill. There’s an even better way to minimize taxes, though: investing in a Roth IRA.
A Roth IRA possesses tax superpowers, but many investors don’t utilize the opportunity it offers. Collectively, a Roth IRA can hold one-tenth of the funds invested in traditional IRAs. Below are four great reasons to consider investing in a Roth IRA.
1. Lock in a tax rate
IRA investors have the opportunity to pay taxes now (Roth IRA) or pay taxes in retirement (traditional IRA). Choosing to make Roth contributions means that you won’t enjoy tax breaks when you invest; however, your money will grow tax-free, and future withdrawals will not attract any taxes.
When choosing whether to invest in a Roth or traditional IRA, the rule of thumb is to invest in a Roth if you think you’ll be in the higher tax bracket at retirement. For instance, investors in their 20s and 30s should choose a Roth IRA since their income will likely increase over the years.
To contribute to a Roth IRA, an individual must have “earned income” for the given year. The annual contribution limit is $6,000 or $7,000 for individuals aged 50 and above. If you file taxes as a single individual, your marginal adjusted gross income must be lower than $139,000 for the tax year and under $206,000 if you file as a couple.
Roth IRA vs. Traditional IRA: To illustrate the traditional IRA, let’s say you are age 25 and earn $37,000 annually. Your federal tax is 12%. If you max your IRA ($6,000), your adjusted gross income will be $31,000, saving you $700 in federal taxes.
Let’s say you put the $700 in taxes on that $6,000 in a Roth account. If you invest the sum for forty years at an average return of 6% starting from age 65, the $6,000 would have turned into about $62,000, all of which can be withdrawn tax-free. But assuming you put the money in a traditional IRA, considering today’s rate of 25%, you’ll owe about $15,000 in federal taxes in retirement.
Paying your taxes now can save you from overpaying later in the future. However, there’s the possibility that your taxes may remain the same or be lower in the future.
2. You’ll be able to access your IRA account without penalties
Another incentive of investing in a Roth IRA aside from the tax advantage is that, unlike a traditional IRA or 401(k), investors can make penalty-free withdrawals from their accounts under any circumstances. For instance, if you put $10,000 in your Roth IRA, and a few years later, you run into some emergencies, you can make withdrawals from the account with no questions asked (since you have already paid taxes on the money).
With other retirement accounts, such withdrawal can attract up to a 50% penalty. The Roth IRA can be both your retirement savings and emergency fund account. It is not a great idea to remove money invested from your retirement account, as every $1 invested when you are 25 years old has the potential to grow to $16 at retirement. This is why withdrawing from your retirement account should be a last resort.
3. No RMD with Roth IRAs
The IRS wants to make sure they retrieve the taxes on retirement accounts like traditional IRAs and 401(k)s, so they force investors to make a mandatory Required Minimum Distributions withdrawal starting from age 72, in most cases. As you make the withdrawal, the taxes for the saved amount are being deducted.
There’s, however, no RMD with a Roth IRA, so you can keep your funds as long as you want and only withdraw when you want.
4. Withdrawals from a Roth IRA Can Help Your Taxes in Retirement
When you make withdrawals from a Roth IRA in retirement, the withdrawals will be tax-free. These withdrawals can help you avoid taking out money from your other accounts and increasing your income taxes, AGI, and other costs.
For instance, let’s say you decide to purchase a car in retirement or make a huge purchase of $20,000. If you withdraw cash from your traditional IRA or 401(k), you will owe taxes on the whole amount and may even trigger an increase in Medicare or bump yourself into a higher tax bracket. But withdrawing from an IRA will have no such issues.
Is it better to invest in a Roth IRA?
The retirement plan you choose should be based on your financial situation. Some investors may need the extra cash now to pay later in retirement. There are even suggestions that when properly invested, the money saved on taxes can generate enough income to cover future taxes.
But for most, paying taxes today will be cheaper than paying in the future, which is why they prefer Roth IRAs.