Roth IRAs are a Crucial Tool for Lowering Taxes in Retirement.
Roth IRAs are after-tax retirement accounts, in contrast to traditional IRAs and most employer-sponsored retirement plans such as 401(k) programs that are tax-deferred accounts (pre-tax contributions). Because of the unique tax structure, Roth IRAs have several advantages.
First, what is an IRA?
IRA is the acronym for Individual Retirement Account. An IRA is a tax-advantaged investment account designed to help Americans save for retirement. Money invested within a Traditional IRA grows over time on a tax-deferred basis. This means that you won’t have to pay capital gains, dividend, or interest income taxes for assets that remain in an IRA. You only pay tax on the money in an IRA once—either when you withdraw it, or prior to contributing it. This is the major difference between the two primary types of IRAs.
The Roth IRA versus Traditional IRA
The distinguishing factor between Roth and Traditional IRAs is the tax treatment of contributions and withdrawals.
In the case of a Traditional IRA—depending on your income level, single or married filing status, and whether you have a retirement plan at work—you may be eligible to deduct your contributions on your income tax return (for the same year the contributions were made). In other words, if you contribute to a Traditional IRA, you can potentially reduce your taxable income and pay less in your current year’s taxes. The trade-off is that withdrawals from a Traditional IRA—both the original contributions and the gains—will be included in your taxable income for the year when they are withdrawn.
On the other hand, a Roth IRA is an after-tax retirement account – you’ve already paid taxes on the money you contribute. Roth IRA contributions are not tax-deductible, but qualifying withdrawals are 100% tax-free, including the gains!
The big advantages of Roth IRAs
There are several reasons to consider a Roth IRA for your retirement savings:
- A Roth IRA lets you lock in your current tax rate since you’ll pay tax on your contribution now, but not on your qualified withdrawals later. No matter how large your Roth IRA grows, you won’t pay a penny to the IRS when you make withdrawals after the age of 59 1/2. This can be especially beneficial if you’re originally contributing while in a lower tax bracket.
- Because you’ve already paid tax on your contributions, you are entitled to tax-free withdrawals of your original contribution amounts (but not investment gains) for any reason, after a five-year waiting period.
- Roth IRAs have no required minimum distributions in retirement. In contrast, tax-deferred retirement accounts such as Traditional IRAs and 401(k)s generally require retirees to start taking minimum withdrawals by a certain age, even if they aren’t needed.
- You can contribute to a Roth IRA at any age, as long as have earned income in that year.
- Because you can leave your money in a Roth IRA indefinitely, they are often used as estate planning tools.
Not all Americans qualify to contribute to Roth IRAs, due to income levels. If you don’t qualify, there is also strategy for circumventing the income limits known as the “backdoor” method of contributing to a Roth IRA. This process is covered in other blogs and videos from my colleagues. Such advanced questions, strategies, and details are best discussed with your financial advisor.