Roth IRAs are retirement accounts to which you can contribute after-tax income as long as you make under a certain amount per year. Since your contributions to Roth IRAs are after-tax, they’re treated differently than contributions made to other types of retirement accounts and come with all kinds of benefits.
Benefit #1: Tax-Free Income
With pre-tax retirement accounts like Traditional IRAs and 401ks, you pay taxes on your withdrawals once you begin to take distributions. But Roth IRAs are different. Since you’ve already paid taxes on the income you contribute, you can withdraw it, as well as the earnings on that income, tax-free upon retirement (or 59 ½ years of age).
This allows you to better control your tax liability upon retirement. For instance, if you have a mixture of retirement accounts: Traditional IRA(s), 401k(s), and Roth IRA(s), the pre-tax accounts (i.e. the Traditional IRA(s) and 401k(s)) will have a minimum annual distribution (i.e. RMD) you’re required to take each year once you’ve reached 70 ½ years of age. So you can take that RMD from each account, and then supplement any other income you need from your Roth IRA without the risk of paying taxes in a higher income bracket.
Benefit #2: You can Withdraw Your Contributions at any Time
Roth IRAs function a little bit like savings accounts in that you can withdraw your contributions at any time, regardless of your age, without paying a penalty or income taxes on your withdrawals. There aren’t even limits on what you can use the money for. If you withdraw your contributions from a pre-tax retirement account before the age of 59 ½ you’ll have to pay a 10 percent penalty off the top as well as income tax on the amount you withdraw.
But keep in mind, this tax-free rule only applies to the post-tax income you’ve contributed, not to earnings that money has made. If you withdraw earnings before reaching the age of 59 ½ you’ll have to pay a 10 percent penalty as well as income tax on the distribution.
The good thing is that the IRS considers all withdrawals as coming from contributions first, and only once contributions are depleted, do they start counting your distributions as coming from earnings.
Benefit #3: Roth IRAs can Help You Leave Tax-Free Money to Your Heirs
Generally speaking, distributions from inherited Roth IRAs remain tax-free. And since the IRS doesn’t require you to take a minimum distribution from the account upon reaching the age of 70 ½ years, you can theoretically pass on 100 percent of your tax-free contributions and earnings to your heirs, provided you don’t need the money to pay any living expenses.
Note: The rules governing inheritance are subtle and complex, so you always want to consult an estate-planning attorney regarding your specific situation.
Benefit #4: Roth IRAs Enable You to Take Advantage of Your Current Tax Base
No one can predict where taxes will be in a year or twenty, but if the government has recently enacted an income tax cut from which you benefitted, or if income tax rates are lower than they’ve been historically, it could make sense to pay taxes on your retirement income now rather than take your chances in the future. Since your contributions to a Roth IRA are post-tax, this type of retirement account allows you to do just that.
In addition to taking advantage of lower tax rates, a Roth IRA allows you to take advantage of a lower tax base. Since you can only contribute to Roth IRAs if you make under a certain amount per year, these accounts make a lot of sense for people just starting out in their careers. In fact, the younger you are, the higher the chance your income will be higher once you retire than it is now. Which means you’ll likely be in a higher tax bracket. Wouldn’t it be nice to have already paid taxes, at a lower rate, on some of that income?
Roth IRAs don’t come with the same tax-deduction benefit that traditional pre-tax retirement accounts enjoy, but they do have a host of other benefits that can actually offset your future liabilities for those other accounts. To get more details on the ins and outs of Roth IRAs, check out our blog post How Roth IRAs Work.
Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.