The Roth IRA is often touted for its tax advantages — namely, that all the money can be withdrawn tax-free in retirement. But there are more benefits of a Roth IRA you should know about.
If your employer offers a retirement plan, such as a 401(k), and will match your contributions, you should take advantage of that opportunity for free money. But if you’re contributing enough to get the match and want to set aside more — or you don’t get an employer match or aren’t offered a retirement plan through work — you should consider a Roth. Below are some great reasons you should open a Roth IRA, but first:
Who Can Contribute to a Roth IRA?
You can contribute up to $5,500 in a Roth IRA in 2015 and stash another $1,000 for a maximum contribution of $6,500 if you’re 50 or older. And you have until your federal tax return is due to make contributions for the previous year. So that gives you until April 2016 to open an account and make a contribution for 2015.
You must have earned income to contribute to a Roth — but you can’t have too much. You can contribute up to the Roth IRA limit of $5,500 (or $6,500) if you’re single and your modified adjusted gross income (AGI) is less than $116,000 or if you’re a married couple filing jointly with a modified AGI of less than $183,000. IRS rules limit the amount you can contribute if you make between $116,000 and $131,000 if you’re single and $183,000 and $193,000 if you’re married filing jointly; you can get cut you off completely from making contributions once you top the higher end of those income limits.
5 Benefits of a Roth IRA
The upfront tax benefits of traditional IRAs and 401(k)s certainly are worthwhile as you’re building your savings. But the Roth will give you the biggest bang for your buck in retirement, said Stuart Ritter, T. Rowe Price vice president and senior financial planner. Here’s why:
1. You get more spendable income in retirement with a Roth IRA.
You might be wondering why you’d want to give up the opportunity to lower your taxes now by contributing to a traditional IRA or 401(k) in favor of tax-free withdrawals in retirement with a Roth. So you’ll have more spendable income in retirement — that’s why.
When you withdraw from a traditional IRA or 401(k) in retirement, you’re going to be hit with taxes on that money, said Walter Updegrave, editor of RealDealRetirement.com. So, you won’t have as much there for spending as you think you have, he said.
Ritter compared saving in a Roth IRA with a traditional IRA and found most people would benefit more from a Roth. His study assumed that investors contributed $1,000 to a Roth and traditional IRA at various ages and were in the 25 percent tax bracket. It also assumed those who contributed to a traditional IRA invested the additional $250 they would get from the tax deduction for contributing to a traditional IRA. Both accounts earn an annualized 7 percent in the years leading up to retirement at age 65 and 6 percent in retirement.
In this case, a 25-year-old in the same tax bracket in retirement would have about 20 percent more spendable income with a Roth than a traditional IRA.
The benefit of a Roth is biggest for those who start saving at an early age because money will have decades to grow tax-free, and they will likely be in a higher tax bracket when they reach retirement age than when they made their contributions, Ritter said.
Even investors who don’t start saving at a young age or whose tax rates will drop in retirement still can benefit more from a Roth. Only if you’re 50 or older and you expect your tax rate to drop significantly in retirement — 9 percent or more — will a traditional IRA become more valuable, he said.
2. You get more flexibility as you save.
The purpose of a Roth IRA is to save for retirement. But if you needed money and didn’t have an emergency fund, you could tap your Roth without the same consequences that you’d have if you took money out of other retirement accounts. You can withdraw your original contributions — not earnings — to a Roth at any time without having to pay taxes or a 10 percent early withdrawal penalty.
You’d have to pay the penalty and taxes on any traditional IRA withdrawal before age 59 ½. You can borrow up to $50,000 from a 401(k), but you have to pay it back within five years, and you’ll pay interest. If you lose your job, you usually have to pay it back in 60 days or be hit with a tax bill and early withdrawal penalty.
You also have a broader array of investment choices with a Roth IRA than you have in your 401(k) menu, Updegrave said. You can invest in anything from CDs and money-market accounts to stocks, bonds and mutual funds. You can also open an account at a bank, a broker or fund company such as Fidelity, T. Rowe Price or Vanguard.
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3. Starting a Roth IRA gives you more flexibility in retirement.
Your expenses won’t remain the same every year you’re in retirement. If you have to withdraw more from your savings in one year because of a big expense, you could be hit with a bigger than usual tax bill, too.
If all of your money is in a traditional retirement account, every dime you withdraw is subject to taxation, Ritter said. Say you want to buy an RV for $75,000. You would have to draw $100,000 to pay for it if you’re in the 25 percent tax bracket to cover the tax bill. Add that withdrawal to the others you make throughout the year and now it looks like you have a much bigger income, which could push you into a higher tax bracket and force you to pay an even bigger tax bill, Ritter said.
Plus, when your income exceeds certain levels, you have to pay more for Medicare and more of your Social Security benefits will be subject to taxes, he said.
“If you have money in a Roth, it gives you flexibility to manage those spiky expenses,” said Ritter. “You’d only need to withdraw $75,000 from Roth and none of that other collateral damage happens” thanks to the tax-free status of Roth withdrawals.
4. You can tap into a Roth IRA to buy a house or pay for college.
In addition to your contributions, you can withdraw up to $10,000 in earnings from a Roth tax- and penalty-free to buy your first home if you’ve had the account for at least five years. The $10,000 limit is per person, so a couple could withdraw up to $20,000. Of course, your retirement savings would take a hit, which is something you should weigh heavily.
You also can withdraw up to $10,000 in earnings penalty-free for qualified higher education expenses. You’ll still have to pay taxes, though. Of course, there are better ways to save for a college education, but the money’s there for you if you’re in a pinch.
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5. You don’t have to take the money out of a Roth IRA.
Although many of us just hope to save enough money for retirement, Updegrave said that diligent savers who will have sufficient income in retirement can benefit from the fact that they aren’t required by law to withdraw money from a Roth in retirement.
You must start taking required minimum distributions at age 70 ½ from traditional IRAs or 401(k)s, regardless of whether you need the money. Roth IRAs aren’t subject to RMDs (required minimum distribution), so you can let the money continue to grow so you’ll have more if you live a long life. Or, you can pass the money onto your heirs.
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