Do you want to help lower your taxes in retirement and increase your retirement savings? A Roth IRA, with its tax-free growth potential and tax-free withdrawals for you and your heirs, is a way you may be able to do just that (as long as certain requirements are met).1 And those are just a few of the benefits of a Roth IRA.
One important note: Not everyone can contribute to a Roth IRA, because of IRS income limits. If your income is over the limits, you still may be able to have one by converting existing money in a traditional IRA or other retirement savings account. (See the section "If you earn too much to contribute," at the end of the article.)
1. Money may grow tax-free; withdrawals are tax-free, too
You contribute money that has already been taxed (after-tax dollars) to a Roth IRA. There's no tax deduction as there can be with a traditional IRA. But, any growth or earnings from the investments in the account—and any distributions you take out in retirement—are free from federal taxes (and may also be free from state and local taxes too), with a few conditions.
2. There are no required minimum distributions
Roth IRAs do not have required minimum distributions (RMDs) for the original owner. Traditional IRAs and, generally, 403(b)s, Roth and traditional 401(k)s, and other employer-sponsored retirement savings plans do. If you don't need your distributions for essential expenses, RMDs may be hard to keep track of.
The RMDs have to be calculated and withdrawn each year, and may result in taxable income. Because a Roth IRA eliminates the need to take RMDs, it may also enable you to pass on more of your retirement savings to your heirs (see below).
3. Leave tax-free money to heirs
In many cases, a Roth IRA has legacy and estate planning benefits, but you need to consider the pros and cons—which can be subtle and complex. Be sure to consult an attorney or estate planning expert before attempting to use Roth IRAs as part of an estate plan. While RMDs are required for inherited Roth IRAs, as they are for inherited traditional IRAs, distributions from inherited Roth IRAs generally remain tax-free.
4. Tax flexibility in retirement
You've already paid the taxes on the contributions to a Roth IRA, so as long as you follow the rules, you get to take out your money tax-free. Mixing how you take withdrawals between your traditional IRAs and 401(k)s, or other qualified accounts, and Roth IRAs may enable you to better manage your overall income tax liability in retirement. You could, for example, take withdrawals from a traditional IRA until your taxable income reaches the top of a tax bracket, and then take additional money you need from a Roth IRA.
5. Help reduce or even avoid the Medicare surtax
A Roth IRA may potentially help limit your exposure to the Medicare surtax on net investment income. This is because qualified withdrawals from a Roth IRA don't count toward the modified adjusted gross income (MAGI) threshold that determines the surtax.
RMDs from traditional (i.e., pre-tax) accounts such as a workplace retirement plan—like a traditional 401(k)—or a traditional IRA, are included in MAGI and do count toward the MAGI threshold for the surtax. So depending on your income in retirement, RMDs could expose you to the Medicare surtax, and using Roth accounts might help you avoid it.
6. Hedge against future tax hikes
Will tax rates rise in the future? There's no way to know for certain, but the top federal income tax rate remains far below its historical highs, and if you think it might go up again, a Roth IRA may make sense.
7. Use your contributions at any time
A Roth IRA enables you to take out 100% of what you have contributed at any time and for any reason, with no taxes or penalties. Only earnings and converted balances in the Roth IRA are subject to restrictions on withdrawals. Generally, withdrawals from a Roth IRA are considered to come from contributions first. Distributions from converted balances and earnings—which can be taxable and/or subject to penalties if the conditions are not met—begin only when all contributions have been withdrawn.
8. If you're older, you can continue to contribute as long as you work
As long as you have earned compensation, whether it is a regular paycheck or 1099 income for contract work, you can contribute to a Roth IRA—no matter how old you are. There is no age requirement for contributions, but you must be within the income limits in order to contribute to Roth IRA.
9. If you're young, your income is likely to rise
Generally speaking, the younger you are, the greater the chance that 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 it is now, at the beginning of your career. And the greater the difference between your income now and your income in retirement, the more advantageous a Roth account can be.
If you earn too much to contribute
In order to contribute to a Roth IRA, you must have employment compensation, and there are also income limits. If your income (as measured by MAGI) is over the IRS limits, the only way you can take advantage of a Roth IRA is by converting money from an existing retirement account, such as a traditional IRA.2 There is a cost, though. You'll generally need to pay taxes on what you convert, but if you have made after-tax contributions to a traditional account, some or all of your conversion may not be taxable. The rules are complex, so if you have made after-tax contributions to a traditional account and you're interested in conversion, be sure to consult with a tax advisor.
It comes down to taxes
No matter what your age, because a Roth IRA may improve your tax picture, it makes sense to take the time to see whether you would benefit from one.