Roth IRAs were created 20 years ago to give investors a way to invest for retirement that allowed for tax-free distributions after age 59 ½.
But they came with a catch.
These new IRAs were to be funded with after-tax contributions. Unlike traditional, tax-deductible IRAs and workplace retirement plans like 401(k) accounts, contributions to Roth IRAs are not tax deductible.
Since then, investors have debated whether it’s best to fund a Roth IRA or a traditional, tax-deductible IRA. Strong arguments can be made for both, but most financial professionals agree: whenever possible, the Roth IRA should be part of your retirement income plan.
Distributions are tax-free. The IRS allows taxpayers to fund their IRAs with contributions of up to $5,500 per year (+ another $1,000 if you are age 50 or older). Like traditional IRAs, these contributions grow tax-deferred until they are distributed from the account.
Unlike traditional IRAs, however, distributions from Roth IRAs are generally tax-free after age 59 ½. On the surface this might seem like two sides to the same coin: traditional IRAs give you a tax-deduction up front, but distributions are taxable. Roth IRAs offer no upfront tax-deduction, but the distributions are tax-free.
If that’s all there was to it, the long-term difference between traditional and Roth IRAs would be minimal. But alas, this is just the beginning.
The real benefit of the Roth IRA isn’t simply that the distributions are tax-free, but that these tax-free distributions give you greater control over your taxable income in retirement. This is the portion of your income that is subject to Federal and state income tax.
Obviously, the lower your tax bracket, the less tax you pay. But if your taxable income is low enough, you also avoid paying taxes on capital gains, your social security benefits may be taxed less, and your Medicare premiums could be lower.
So by having a tax-free source of income in retirement, your overall tax burden may be lower allowing your retirement savings to last longer.
There are no RMD requirements. Another benefit of Roth IRAs is that there is no required minimum distribution (RMD) that must come out of your IRA at age 70 1/2.
Many retirees have enough income from other sources that they can afford to delay their IRA distributions indefinitely. However, with traditional IRAs the IRS requires IRA owners to begin taking at least a minimum distribution starting on April 1 of the year after they year they turn age 70 ½.
If you have a large IRA balance, these distributions can be significant. Often these additional distributions push retirees into higher tax brackets even though they don’t actually need the extra income. As described above, this additional income can lead to a host of other tax related side effects.
Roth IRAs however, have no such RMD requirement. So, not only is the distribution tax-free, but you are in control of if and when you take distributions from your account. In some cases, you may choose not to ever take a distribution from your Roth IRA allowing the entire balance to transfer to your beneficiaries at death completely tax free!
They are more liquid. Contributions to Roth IRAs can be distributed free of tax and penalty at any time, for any reason.
Except under a few specific circumstances, traditional IRAs require you to leave your money in the IRA until age 59 ½. Distributions before that time are taxable and subject to an extra 10% penalty.
Since Roth IRAs are funded with after-tax contributions, the IRS allows Roth IRA owners to take out their principal at any time for any reason without a tax or penalty. If you contribute $5,500 a year to a Roth for 10 years, that’s $55,000 you can take out of your account without any tax consequences. This can be especially important for those who have college tuition to pay, suffer a job loss or experience other “short-term liquidity events” before retirement.
Controlling your taxable income is the key to paying less tax in retirement and making your hard earned retirement savings last as long as possible. Roth IRAs offer tax-free retirement income, avoid needless distributions and offer greater liquidity between now and retirement.
Now, more than ever, Roth IRAs should be part of your retirement income plan.