Opening an individual retirement account is an excellent step in retirement planning. However, you’ll face a choice when doing so: will you pick a traditional IRA or Roth account? Your contributions to one count toward the total annual limit for both account types, so your choice is crucial. A Roth IRA carries numerous benefits for your tax circumstances. Here are the primary benefits of Roth IRAs that you may not know. 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 government-taxed money. For example, say you receive a $2,000 paycheck from your employer every two weeks. This money comes to you after taxes are taken out. You deposit $200 of each paycheck to 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 deduction while you work and incurs taxes in retirement when you make withdrawals.
Top Benefits of Roth IRAs
Roth IRAs are distinct from traditional IRAs and can help your tax situation in the following ways:
Tax-Advantaged Returns
Income taxes are due on withdrawals made from tax-deferred accounts like traditional IRAs and 401(k)s. As a result, you end up paying taxes on your initial contribution and any investment earnings. With a Roth IRA, you won’t owe taxes on your investment earnings because your account is funded with after-tax contributions. This aspect increases your income during retirement and minimizes the account’s fees.
Withdrawal Flexibility
Roth IRAs also allow you to withdraw money before retirement. Specifically, you can withdraw your contributions at any age without incurring a penalty. However, you must have had the account for at least five years before accessing your investment earnings without paying a penalty. Likewise, you’ll draw a financial penalty when withdrawing earnings from a Roth IRA if you haven’t reached the age of 59 ½.
That said, several exceptions allow you to skirt the penalties. For example, first-time home buyers can withdraw $10,000 from the account anytime to help with the down payment. In addition, you can cover qualified expenses for education, medical expenses, adoption or birth. Lastly, your funds are accessible if you pass away or suffer a disability.
Remember, the five-year rule applies after you turn 59 ½. So, withdrawals after that age from an account you’ve held for less than five years will still incur taxes and/or penalties. However, once you pass the generation and five-year milestones, your funds are completely accessible without taxes or fees. Therefore, you can withdraw as much money as you want per year without changing your tax situation.
No RMDs
Required minimum distribution (RMD) rules enforce mandatory withdrawals from many types of retirement accounts. In short, the laws make retirees take money from their retirement accounts at age 73, even if they don’t need it. Fortunately, Roth IRAs are exempt from this rule, meaning your funds will sit in your account, earning returns until you need a distribution.
No Tax Burden for Beneficiaries
Your Roth IRA funds are equally untaxable if you pass away and leave your account to your designated beneficiaries. However, RMD rules still apply, meaning the loved one who receives the IRA must eventually withdraw all the money from the account.
Reduced Income Taxes
Because Roth IRA distributions don’t have tax implications, they are helpful if you expect substantial income during retirement. For example, if you make less than $94,300 and file your taxes jointly with your spouse, you’ll stay in the 12% tax bracket. Doing so with a Roth IRA means paying this low rate while you work. Then, your distributions in retirement won’t be subject to taxes and potentially push you into a higher tax bracket.
Pairing with Other Account Types
Your Roth IRA provides tax diversification when you contribute to another retirement account. For instance, if your employer offers a 401(k) plan, you can make pre-tax contributions there and after-tax contributions to your Roth IRA. This option spreads your tax burden across your working years and retirement, reducing financial strain in both stages of life.
Disadvantages of a Roth IRA
While Roth IRAs offer a host of benefits, they come with several drawbacks:
Income Level Prevents Accessibility
IRS regulations prohibit Roth IRAs for those with too high of a modified adjusted gross income (MAGI). If you’re married and filing jointly with aa MAGI of $230,000 or less in tax year 2024 you can make a full contribution to a Roth IRA (up from $218,000 in 2023). Those with a MAGI between $230,000 and $240,000 can make a reduced contribution to a Roth IRA (up from $218,000 to $228,000 in 2023), while couples whose MAGI exceeds $240,000 lose the ability to make a Roth IRA contribution in 2024.
Filing single or as head of household brings similar limits. Specifically, the income limit for these tax situations is $146,000 for tax year 2024 (up from $138,000 in 2023). Those with a MAGI between $146,000 and $161,000 can contribute a lower amount to a Roth IRA while those with MAGI above $161,000 can no longer contribute to a Roth IRA (up from $153,000 in 2023). Conversely, traditional IRAs have no income limits, meaning anyone can contribute to one.
Contribution Limits
Another downside of IRAs is their low annual contribution limit. Specifically, you can contribute $7,000 to an IRA in 2024 and $6,500 in 2023. If you’re 50 or older, you can contribute an additional $1,000 in tax years 2023 and 2024. As a result, you might have to open an additional retirement account, such as a 401(k) or 403(b), to save enough for retirement.
No Immediate Tax Deduction
A Roth IRA can’t use pre-tax dollars. As a result, you can’t lower your income taxes with a Roth IRA during your working years. This aspect can hurt your tax situation if you expect your income to be significantly higher in your career than in retirement. For example, if you make $95,000 in 2024, you’ll pay a 22% marginal tax rate on your income before depositing it into your Roth IRA. On the other hand, placing pre-tax dollars in a traditional IRA and planning to withdraw $44,000 each year in retirement means you’ll end up paying only a 12% marginal tax rate.
Conversion Limitations
Because income can limit your ability to contribute to a Roth IRA, conversions are a popular option for high-income individuals to obtain this account type. Specifically, you can open a traditional IRA, contribute to it, then convert it to a Roth IRA. Doing so requires you to pay income taxes on contributions. In addition, the downside here is that you can’t convert back to a traditional IRA once it becomes a Roth. So, it’s best to only perform a conversion with a detailed plan in place.
Alternative Retirement Accounts
Because your tax situation or income level might make the Roth IRA subpar or unviable, you can branch out into other retirement-saving options. Consider the following:
- Traditional IRA: A traditional IRA has no income limits, meaning your annual payments won’t prevent you from contributing to the account. However, the annual contribution limits ($7,000 in 2024 and $6,500 in 2023) still apply.
- Brokerage Account: You can also open a taxable brokerage account if you want more accessibility to your funds, with the tradeoff being capital gains taxes on your returns.
- Employer-Sponsored Plans: Accounts such as 401(k) and 403(b) accounts, are excellent options. You can receive matching contributions from your employer and contribute up to $23,000 in 2024 and $22,500 in 2023. Plus, those over age 50 can deposit an additional $7,500.
Bottom Line
Roth IRAs offer unique tax benefits and withdrawal options for account holders. Specifically, you won’t pay income taxes in retirement on distributions from the account and you can withdraw your contributions at any time. Plus, they’re accessible to anyone with earned income and a MAGI below the annual income limits.
That said, the Roth IRA’s biggest tax advantage can also be its downfall. If you would rather save pre-tax dollars and pay taxes in retirement, it’s best to contribute to a traditional IRA. In addition, the low annual contribution limit may force you to look elsewhere to save money for retirement. As a result, evaluating your retirement plan and tax circumstances is necessary to know if a Roth IRA makes sense.
Tips for Having a Roth IRA
- Understanding whether pre- or post-tax retirement contributions are optimal can be difficult. Your financial situation is unique and you’ll need to account for every aspect of your circumstances to understand if a Roth IRA is best for you. Fortunately, a financial advisor can help you make sense of your options. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- As mentioned, the Roth IRA is just one of many retirement plans available. You can read more about the best retirement plan types to pick one that suits you.
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