This article was updated on May 12, 2016.
Many investors look to IRAs at tax time as a quick way to cut their tax bills. A Roth IRA won't give you the immediate gratification of an upfront tax deduction that will boost your refund for this year, but it will lower your future taxes by a considerably larger amount. Let's look more closely at how the Roth IRA works, and how much in tax savings you're likely to get by using one.
How Roth IRAs are different from traditional IRAs
It's easy to get confused between different types of IRAs. The traditional IRA does give you the chance to lower your taxes right away, as contributions to traditional IRAs are generally tax deductible. The deduction usually results in tax savings that correspond to your marginal tax bracket. So if you're in the 25% bracket, then a $4,000 traditional IRA contribution would typically save you $1,000 on your tax bill.
Roth IRAs, however, don't get this type of favorable tax treatment from the IRS. You're not allowed to deduct your contributions to a Roth IRA, effectively forcing you to use after-tax money to put toward your retirement savings in these vehicles. Instead, the IRS gives Roth IRA holders a big benefit when it comes time to make withdrawals from their accounts. That means that a Roth IRA typically won't lower your taxes at all right away, but it can lead to a big payoff later on.
Tax-free distributions from Roth IRAs
When you choose a Roth IRA over a traditional IRA, you sacrifice an upfront deduction for the chance to get tax-free treatment on your retirement account's income and gains. If you wait until you reach age 59-1/2, and have had your Roth IRA open for at least five years, then distributions you take from your Roth are free of tax, no matter whether that money represents your initial contributions, or the earnings and gains that those contributions generated. By contrast, money that you take out of a traditional IRA is generally subject to income tax in the year that you withdraw it.
For example, take the same $4,000 IRA contribution mentioned above. Say you make that contribution early in your career, and earn an average annual return of 8% on your money over 30 years. By the end of that time, assuming you've made no additional contributions, your IRA will have grown to about $40,000. If you used a traditional IRA, that $40,000 would be taxable when you withdraw it, producing a $10,000 tax bill if you remain in the 25% bracket.
If you use a Roth IRA, then the full $40,000 is free of federal income tax. That effectively saves you $10,000 in the example above -- or whatever income tax that amount would have generated based on your particular tax bracket.
One upfront tax break for Roth IRAs
There's one exception to the rule that Roth IRAs don't give you an upfront tax break. Some low- and middle-income taxpayers can use the Saver's Credit to earn tax savings of between 10% and 50% of the first $2,000 they contribute to a retirement account such as an IRA or a 401(k). Roth IRAs qualify for this treatment, as well.
The big savings from a Roth IRA come late in life. By giving you a tax-free source of retirement funds, Roth IRAs provide financial flexibility that other retirement accounts can't match.
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