Roth IRAs offer a lot of perks compared to other retirement accounts. Understanding these perks and how they could benefit you can help you decide whether a Roth IRA is right for you.
Tax-Free Growth With a Roth IRA
The greatest benefit of a Roth IRA is that the money in the account can grow completely tax free. You don’t pay taxes on any activity in the account. There are no taxes on any capital gains or dividends that you might receive from your investments. Other retirement accounts such as a 401(k) or a traditional IRA provide the same benefit while the money remains in the account, but you’ll pay taxes when you eventually withdraw funds. You’d have to pay taxes on dividends and capital gains with a regular investment account. This can slow down the growth of your portfolio because you may have to use some of your investments to pay those taxes. This reduces the amount of money you have invested and, in turn, the impact of compounding growth.
Roth IRA Withdrawals Are Tax Free
What sets Roth IRAs apart from traditional IRAs and other retirement accounts is that the withdrawals you make from the account are tax free. You pay taxes on the money before contributing it to a Roth IRA, so you don’t have to pay taxes on the principal or the earnings when you withdraw the funds. If you withdraw $10,000 from a traditional IRA, you must report that withdrawal as $10,000 in income. You’ll typically owe taxes on that income, which will reduce the amount you can actually use for living expenses or other purposes. But you’ll owe no taxes if you withdraw $10,000 from a Roth IRA. You can use the full amount for whatever you’d like.
Greater Flexibility for Early Withdrawals
You’ll enjoy tax incentives that help build your savings when you contribute to a retirement account, but you’ll also face restrictions on how you can use the funds that you’ve contributed. You must typically wait until age 59½ before withdrawing money from a traditional IRA or a 401(k). Most withdrawals prior to reaching that age will incur a 10% penalty in addition to the taxes you’ll owe, although there are some exceptions. You can begin withdrawing Roth IRA earnings after you reach age 59½, as long as the account has been open for at least five years. There are a few scenarios in which you can avoid taxes, penalties, or both on early withdrawals from a Roth IRA if you’re younger than 59½, even if it hasn’t been open for a full five years. For example, penalty-free withdrawals may be allowed to pay for a first-time home purchase, qualified education expenses, or medical expenses.
A Roth IRA Lets You Avoid RMDs
Account holders must begin making annual required minimum distributions (RMDs) from traditional IRAs or 401(k)s starting in the year after they turn 72. The size of these RMDs varies with the account holder’s age and the amount of money held in their IRA or 401(k). Being forced to make these withdrawals can make tax planning more difficult because you have less control over when and how much money you take out of the account. Because withdrawals from traditional retirement accounts count as income, making a large withdrawal in a particular year can mean paying a lot of taxes. Roth IRAs have no RMD requirements for as long as the account holder remains alive, giving you more control over how and when you use the money in the account.
Should You Open a Roth IRA?
A Roth IRA is a good choice for many savers, but it works better in some situations than others.
When a Roth IRA Works Best
Investors pay taxes on money before contributing it to a Roth IRA, then they pay no taxes on withdrawals. Traditional IRAs provide an upfront tax break in exchange for paying taxes on withdrawals in retirement. This means that a Roth IRA may be a good choice for a younger saver with less income who is in a lower tax bracket. Choosing a Roth IRA will minimize the overall amount of tax they’ll pay If they expect to be in a higher tax bracket later in life.
Who Might Prefer a Traditional IRA
A traditional IRA offers an upfront tax incentive so people who earn higher incomes can save money by contributing to this type of account. If you expect to be in a lower tax bracket during retirement than you are when you make the contributions, using a traditional IRA is typically a better choice.
Roth IRA Restrictions
One thing to keep in mind is that there are restrictions on who can contribute to a Roth IRA. The primary rule is based on your income. You must stay below a certain level of income to contribute to a Roth account. The amount you can contribute starts to decrease until it reaches $0 if your income exceeds a limit based on your filing status. Here are the income limits for 2022: The federal government often increases these limits annually to keep pace with inflation. They go up in 2023.
The Bottom Line
Roth IRAs are one of the best ways to save for retirement, especially if you’re in a low tax bracket. The opportunity to have your investment grow tax free for decades can help you avoid paying thousands of dollars in taxes that you’d otherwise have to pay. But keep in mind that a traditional IRA may be a better choice for some people. Consider speaking with a financial advisor if you’re not sure which retirement account is right for you. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
