When it comes to the world of IRAs and preparing for retirement, it can sometimes be confusing deciding between a traditional and a Roth IRA and determining which is right for your unique needs and goals.
Of course, there's no rule saying you can't have both, but it's a good idea to understand the unique benefits that a Roth offers over a traditional IRA. To help break that down we reached out to some of the industry's leading financial leaders. Here's what you need to know about Roth IRAs and why you might want to have one.
No minimum required distributions during retirement and tax-free growth.
Perhaps two of the most important features of a Roth IRA are its tax benefits and the elimination of minimum required distributions during retirement. Here's why these two things matter so much.
Roth IRA contributions are made with after-tax money, and because you've already been taxed on the cash, the earnings in your IRA are allowed to grow entirely tax-free. Furthermore, because you're not required to take distributions from the account once retirement arrives (which distinguishes the Roth from many other retirement vehicles), the money can be left in the account to continue growing and growing, and growing tax-free for well….as long as you want.
"One of the main benefits is that the money invested can grow tax-free until you need it," says Rita Assaf, vice president of retirement and college saving leadership at Fidelity Investments.
A hedge against tax hikes.
Speaking of all that tax-free growth in your Roth IRA, no one really knows for certain whether tax rates will rise in the future. But it's a pretty good bet they will be increased at some point. However, as we just covered, withdrawals from a Roth IRA are not taxed. What's more, the money in your account grows tax-free—all of which can be a pretty great hedge against any future tax hikes. In other words, yet another reason to add a Roth IRA to your retirement portfolio.
There are some caveats to consider, however, with regard to this particular benefit. For example, you're being taxed on the money put into a Roth at your present tax rate, which could actually end up being much higher (if you're in your top earning years) than the tax rate you may be subject to as a retiree. (Often, as a retiree your annual income is lower, and thus your tax rate is lower too).
"Do you believe that you're going to have a higher tax rate, or the same tax rate when you retire?" asks Sri Reddy, senior vice president of retirement and income solutions at Principal. "If you think your tax rate may be higher in retirement, a Roth IRA may be a good choice as you're taxed at your current income bracket. If like many people, you expect to be in a lower tax bracket in retirement, you may be better off in a Traditional IRA."
(Contributions to Traditional IRAs are made with pre-tax dollars, and you're taxed on withdrawals during retirement at whatever your tax rate happens to be at that point.)
Giving some thought to your tax rate now, and what it is likely to be during retirement, can help determine whether you should have a Roth IRA in your portfolio. These are especially important questions for the youngest of Roth investors.
"Generally speaking, the younger you are, the greater the chance your income will be higher when you retire than it is now. For instance, if you're under age 30, it's possible that your income and spending during retirement will be significantly higher than they are now at the beginning of your career," says Assaf, of Fidelity.
The greater the difference between your income now and your anticipated income in retirement, the more advantageous a Roth account can be because it will shelter that money from being taxed at a higher rate upon withdrawal.
Money can be withdrawn before retirement without penalties.
Yet another attractive feature about Roth IRAs, especially for younger investors, is the ability to withdraw money from the account before retirement without penalty.
"Contributions can be withdrawn tax-free and penalty-free at any time, for any reason," explains Assaf. "In addition, as long as five years have passed since your first Roth contribution, earnings from a Roth IRA can also be withdrawn federally tax-free and penalty-free provided you use the money for specific reasons such as qualified higher education expenses (which can include college-related expenses), qualified first home purchases up to $10,000, and certain medical expenses."
You can start saving at an early age.
As long as you're over 18 and have income that's not above the limits ($139,000 for 2020 and 2021 if you're single), you can open, and begin contributing to a Roth IRA.
"What's more, kids under the age of 18 can also start saving in a Roth IRA. These are Roth IRAs that can be opened and managed by an adult—parent, grandparent, aunt, uncle, a family friend—on behalf of a minor earning income such as babysitting, mowing lawns, or shoveling snow," says Assaf.
Contributions can be made as long as you're earning money.
Another added benefit of a Roth IRA, and another good reason to have one, is the ability to contribute money no matter how old you are—as long as you have earned compensation, whether it is a regular paycheck or 1099 income for contract work.
"There is no age requirement for contributions," says Assaf. "Though you must be within income limits to contribute to a Roth IRA."
If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $140,000 for the 2021 tax year in order to be able to contribute to a Roth IRA. For those who are married and filing jointly, your MAGI must be under $208,000 for the 2021 tax year.
Should you have a Roth IRA?
So, what's the bottom line when it comes to Roth IRAs? Given their many benefits, a Roth can be a solid addition to your retirement portfolio, one you won't want to miss out on in many cases. But ultimately, it's a personal decision, one that should be weighed based on your unique financial needs including your current tax situation and your potential tax bracket in the future (a question that should encompass where you will likely be living during retirement, and what the tax and pension laws are in your intended destination).
You should also think carefully about your financial needs during the years prior to retirement. Does your future include having to pay for college for children? Or other major life expenses, such as home purchase, which may involve tapping into your retirement accounts? These are questions to consider carefully because a Roth will allow you to access the cash, while a Traditional IRA will come with penalties for doing so.
"A Roth IRA allows you the flexibility to make early withdrawals without penalty under certain circumstances. Contributing to a Roth IRA also can give you the freedom to spend withdrawals, because the withdrawals are generally not subject to tax if certain requirements are met," says Mary-Charles Nassif, a financial advisor with Edward Jones. "In comparison, with a traditional IRA, contributions are typically tax-deductible, earnings grow tax-deferred, and you'll generally pay income tax on withdrawals."
While a Roth IRA certainly provides flexibility, and withdrawals are generally tax-free, there can be cons to this type of easy access, cautions Nassif. Since your Roth IRA is designed to provide income during retirement, too many withdrawals can deplete your savings, changing how your retirement years will ultimately be spent.