Everyone has at least a few options when it comes to retirement savings accounts.
There are few barriers to opening a traditional or Roth independent retirement account (IRA), for example. Additionally, many employers offer retirement plans. These include 401 (k) accounts, profit-sharing plans, and, although increasingly rare, defined benefit pension plans.
So, why consider using a Roth IRA as a long-term vehicle for retirement savings and investing? Let’s review what Roth IRAs are and how they work. Then we’ll look at the benefits, as well as the drawbacks, of Roth IRAs.
What is a Roth IRA?
A Roth IRA is a tax-advantaged retirement savings account. It allows individuals to save aggressively for retirement while taking advantage of impressive tax savings.
Roth IRAs can hold a variety of assets including stocks, bonds, ETF’s, and mutual funds. The money in these accounts grows tax-free. That tax-free growth allows account holders to avoid some taxes in retirement.
How Roth IRAs Work
Roth IRAs are similar to traditional IRAs except in how they are taxed. Traditional IRA deposits are made with pre-tax dollars. However, traditional IRA account holders must pay taxes on the distributions paid to them from those accounts.
Roth IRAs, on the other hand, are funded with after-tax dollars. Because tax is paid upfront, no tax is owed when it comes time to take qualified distributions from these accounts, with some exceptions.
Much like a traditional IRA, a Roth IRA acts as a savings account for investments. Opened at either a bank or brokerage, the account owner decides what they want to invest in.
Popular choices include mutual funds, stocks, bonds, exchange-traded funds (ETF’s), and bank savings products. The account holder may invest one lump sum or make smaller contributions throughout the year.
As of 2024, the maximum annual contributions made to a Roth IRA cannot exceed $76,000. This number jumps to $8,000 for account holders over 50 years of age.
Roth IRA Benefits
Roth IRAs offer numerous benefits. For example, a Roth IRA allows the account holder to withdraw money without taxes or penalty as long as they meet two simple qualifications, explained later in this section. This is different than a traditional IRA or 401(k) contribution plan.
Another benefit: Individuals can make contributions to both a Roth IRA and a 401(k) at the same time. This makes it possible to increase the amount of money saved for retirement. The investment growth in both a Roth IRA and a 401(k) is tax-deferred until retirement.
Those wishing to open a Roth IRA can choose when and how much money they contribute. While some people choose to contribute the maximum amount of $7,000 ($8,000 for taxpayers over 50) in one lump sum, many others prefer to spread this amount throughout the year.
As long as taxpayers stay within the annual maximum, they can make as many contributions as they wish within a one-year period. Participants have until the tax deadline of April 15th to contribute for the previous year.
Distribution and Tax Benefits of Roth IRAs
At 59 ½ years of age, investors can take distributions, including earnings, from their Roth IRA without paying federal taxes, provided they have held the account for at least five years.
Because the contributions can be withdrawn at any time without taxes or penalties, this type of savings account is ideal for individuals with specific future goals. Examples include buying a house or paying for a child’s college education.
Additionally, Roth IRAs do not require account holders to take required minimum distributions (RMDs). This means funds can remain in the account until you want to withdraw and use them.
That’s a key benefit of a Roth IRA over a 401 (k), or at least a traditional 401 (k). Starting in 2024, RMDs are no longer required from Roth 401 (k) plans.
Anyone can open a Roth IRA as long as they have earned income, but contributions are subject to an income limit. Earned income can come from a variety of sources and includes all income earned from working for someone else, or self-employment. Additional forms of earned income include untaxed combat pay, military differential pay, taxed alimony, and disability benefits.
Who Benefits the Most from Using a Roth IRA?
Roth IRAs are an excellent choice for anyone who believes their tax rate might go up in the future. Since taxpayers contribute to Roth IRA’s using after tax money , it only makes sense to make these contributions when they believe their tax rate is lower than it will be down the road.
However, opening a Roth IRA makes sense even for people who aren’t sure what their future tax bill will look like. Advantages like no RMDs and tax-free withdrawals are useful for many retirees.
Downsides of Roth IRA
Like any other tax-advantaged retirement plan, the IRS has specific rules regarding contribution limits, income limits, and how account owners can withdraw their money. $7,000 is the maximum annual contribution allowed for 2024. However, account holders over 50 can contribute up to $8,000.
It’s important to note that annual contributions cannot exceed earned income and couples cannot obtain a joint Roth IRA. This can make obtaining an account difficult if one spouse earns more than the other. However, couples can still accomplish their goals of if each spouse opens their own Roth IRA.
Perhaps the biggest downside for Roth IRAs is that some people make too much money to contribute to this type of account. IRS income limits for Roth IRA eligibility are based on modified adjusted gross income (MAGI). Individuals must make less than $124,000, or $230,000 from married couples, to contribute the maximum amount and less than $143,000 to contribute a reduced amount.
Individuals who earn over $146,000, or $240,000 for married couples, cannot contribute to a Roth IRA.
Another drawback: Account holders cannot contribute unearned income to a Roth IRA. Unearned income includes any type of investment income earned from securities, rental property, or other assets.
Paying Taxes on Roth IRA
Unlike traditional IRAs, which have an up-front tax deduction, account holders make contributions to a Roth IRA with income that’s already been taxed. Roth IRA account holders cannot get a tax deduction on the earnings they contribute.
For example, if an individual contributes $5,000 each year to a Roth IRA, they pay taxes on that money each year before making their deposit.
Since all tax is paid upfront on all contributions to a Roth IRA, all returns the investment earned over the life of the account are tax-free. Once the account holder meets the 59 ½ age limit and 5-year holding period requirements, they can begin making withdrawals from their Roth IRA without any tax liability.
Instead of getting the tax break up front, Roth IRA account holders get it on the back end of the investment. That can be especially helpful in retirement, where the majority of funds may come from existing assets as opposed to new income generated through employment.
Is a Roth IRA Right for You?
Roth IRAs offer some clear benefits. At the same time, their drawbacks are mostly limited to contribution caps and limits on contributions or exclusions for high earners. Additionally, almost anyone can open an IRA as long as they have earned income.
Choosing effective retirement accounts is especially important, but this decision is still part of the bigger picture of retirement planning. Everyone has different wants and needs when it comes to retirement, and there’s no single strategy that will work for everyone.
In many cases, a Roth IRA can be a good decision to save for retirement. In others, it may be more beneficial to choose a different approach.
A fiduciary financial advisor can use their knowledge and experience to inform you and help you make these complex and important decisions. Fiduciaries are bound by law to always act in your best interests. That means the advice and suggestions they provide are focused on delivering positive outcomes for you, not earning commission or selling specific products.
At Dechtman Wealth Management, we’re dedicated to helping our clients meet their financial goals. Our fiduciary financial advisors can help you build, monitor, adjust, and carry out a comprehensive retirement plan that puts your unique needs first.
Please contact us for more information about Roth IRAs.
