Individual retirement accounts (IRAs) give investors a fantastic opportunity to save on taxes. Pay your future self by investing in an IRA, and you can also lower your income tax bill. Clever retirement investors know an even better strategy to minimize their taxes, though: Use a Roth IRA.
Roth IRAs can give you tax super powers, but they’re still drastically underutilized: Collectively, they hold about one-tenth of the funds invested in traditional IRAs. Here are four reasons why you should consider saving for retirement with a Roth IRA right now.
1. Lock in Your Current Tax Rate with a Roth IRA
The basics of a Roth vs traditional IRA are simple: Investors can choose to pay taxes on contributions now by contributing to a Roth IRA or pay them later in retirement by contributing to a traditional IRA.
Choosing to make Roth contributions means there’s no break on this year’s tax bill. When you retire, however, withdrawals from a Roth IRA don’t increase your taxable adjusted gross income (AGI). In all likelihood, your Roth contributions have compounded dramatically over the years, giving you an even more valuable tax break.
When it comes to choosing a Roth vs traditional IRA, consider this general rule of thumb: If you think you’ll be in a higher tax bracket when you retire than you are today, go with a Roth IRA. Young people in their 20s and early 30s who are just starting out in their careers are one demographic who should probably choose Roth contributions—since their income and tax rates will likely rise much higher later in life years.
As with all tax-advantaged accounts, there are rules about who can utilize Roth IRAs, but they’re pretty liberal. First, you must have an earned income in a given tax year. If you file taxes as a single person, your modified adjusted gross income (MAGI) must be under $139,000 for tax year 2020 (this rises to $140,000 in tax year 2021). Married couples’ MAGI must be under $206,000 for 2020 (rising to $208,000 in 2021).
Whether you’re single or coupled, though, you may be able to get around these income restrictions with a backdoor Roth conversion.
Annual IRA contribution limits in 2020 and 2021 are $6,000 or $7,000 for those 50 and over.
Tax Advantages of a Roth IRA vs Traditional IRA
Pay your taxes now or pay them later—this might sound like a negligible difference. You might even be tempted by the immediate tax savings of a traditional IRA. Here’s another way to look at it.
Say you are 25 years old and earn $37,000 a year. Your federal tax bracket would be 12%, for a federal income tax bill just shy of $3,000. If you contributed $6,000 to a traditional IRA, you’d lower your AGI to $31,000, saving you about $700 in federal taxes. That’s a tidy tax refund.
But let’s say you paid the $700 in taxes on that $6,000 and put it in a Roth IRA instead. Then assume you invest that sum for 40 years and earn an average 6% return. By age 65, you’d have turned that $6,000 into nearly $62,000, all of which could be withdrawn tax-free.
Had you put that money into a traditional IRA, assuming a tax rate of 25%, you could end up owing Uncle Sam about $15,000 on that money. So you’ve traded a $700 tax bill today for $15,000 tax savings at retirement. That’s a pretty good deal.
This is a generic example, of course, and plenty of other factors could alter a real-life calculation, but you get the idea. Paying your taxes now can save you a lot over paying your taxes later.
And there’s another compelling factor: You won’t have to look hard to find economists who think the national debt and current government spending levels are unsustainable, so tax rates will have to increase over time. If you believe that, there’s another big reason to pay taxes at today’s rates.
2. Access Your Roth IRA Contributions Without Penalty
If these eye-popping numbers don’t get you interested in a Roth IRA, consider another set of incentives that make it unique among tax-advantaged accounts.
Unlike most 401(k) plans and traditional IRAs, Roth IRAs allow penalty-free withdrawals of contributions under certain circumstances. Say you put in $5,000 a year for four years, then run into a family emergency, like a sudden job loss or illness. You can withdraw the $20,000 in contributions, no questions asked—you’ve already paid taxes on that money. (Your tax-free earnings can’t be withdrawn so easily, though.)
In other retirement accounts, you’ll face an early withdrawal penalty, barring certain approved circumstances. That means Roth IRAs are a perfect vehicle for someone starting out who knows they need to build up emergency savings and retirement savings but can’t imagine doing both at the same time.
Furthermore, Roth IRA earnings can also be withdrawn penalty-free in a few situations, like a home down payment, expenses related to a new child, certain healthcare costs or higher education expenses. This is true of most other retirement accounts, but Roth IRAs have one unique advantage: If your first Roth contribution was at least five years ago, your earning withdrawals for these circumstances are tax-free.
Now, it’s not a great idea to remove money from any retirement account early. Using a Roth like a savings account would be a mistake. Average investment returns over the decades mean that every $1 you withdraw at age 25 could have grown to $16 by retirement. That’s why it’s important to build up an emergency fund while contributing to your retirement.
Still, those who hesitate to save for retirement early in their adult lives because their bank accounts are dangerously close to zero should feel comforted by the way Roth IRAs are designed. It’s also a little easier for young people to put money into a Roth and avoid that “40 years is a long time to sock this money away; I’ll never see it again” feeling.
3. No Required Minimum Distributions (RMDs) with Roth IRAs
Roth IRAs offer unique benefits at the other end of the investment story, too—there are no required minimum distributions (RMDs).
Uncle Sam wants to make sure he eventually gets tax revenue from funds saved in other types of tax-advantaged retirement accounts. So the IRS mandates that you begin withdrawing RMDs from most retirement accounts based on IRS life expectancy tables. That means you’ll have to pay taxes on traditional IRA funds starting at age 72 in most cases.
RMDs increase your income later in life, potentially increasing your tax bill and possibly impacting other means-tested benefits, such as Medicare premiums. The option to leave your Roth IRA savings untouched grants it a big benefit over other retirement vehicles.
4. Roth IRA Withdrawals Can Help Your Taxes in Retirement
When you decide to dip into your Roth IRA funds, withdrawals are tax-free. These tax-free withdrawals can help you to put off the need to take cash out of other accounts that could increase your AGI, income taxes or other costs.
Here’s an example: Consider a retiree who needs $10,000 to pay for a big vacation or $30,000 for a new car. They might decide the best way to avoid debt is to withdraw the cash from a retirement account. A retiree who withdrew the sum from a traditional IRA would owe income taxes on the entire amount, starting a negative chain reaction. They might bump themselves into a new tax bracket or even trigger an increase in Medicare premiums. But a retiree who withdrew that amount from a Roth IRA would face no such problems.
Should You Open a Roth IRA?
Roth IRAs aren’t perfect. For starters, people who work second and third gig-economy jobs can end up with big tax bills at the end of the year because payroll departments aren’t taking out tax withholdings proactively, and they might really need the present-year tax break a traditional IRA provides. Some taxpayers simply might really need that extra cash right now or at tax refund time.
There is even an argument that the $1,000 or so present-day tax savings generated by maxing out contributions to a traditional IRA, if invested well, can generate enough returns over several decades to balance out the later-in-life tax savings that could come from a Roth IRA. That’s an investment bet that isn’t for the faint of heart, however, because of the uncertainty of any future returns.
For many taxpayers, the simple truth is that paying taxes today will be cheaper than paying taxes at retirement—and that’s why they should seriously consider a Roth IRA.