Stick It to the IRS With This Tax-Free Retirement Account

When it comes to retirement saving in an IRA, you have two basic options -- traditional or Roth. Both offer some valuable benefits, like the ability to avoid capital gains and dividend taxes every year, but they differ in their tax treatment. While a traditional IRA can get you a nice tax deduction this year, a Roth IRA can potentially save you hundreds of thousands' worth of taxes in retirement and offers some other benefits you should know about as well.

What is a Roth IRA?

A Roth IRA is a retirement account designed to help low- to moderate-income taxpayers save and invest for retirement.

Roth IRA contributions are made on an after-tax basis, meaning that you contribute money you've earned, but you cannot claim a tax deduction for your contributions. However, your investments can grow and compound tax-free over the years, and your withdrawals in retirement won't count as taxable income, no matter how big your account gets. In other words, even if your Roth IRA swells to several millions of dollars in value (which does happen), the IRS can't touch one cent.

Image source: Getty Images.

For the 2016 and 2017 tax years, IRA contributions are limited to $5,500 per person per year, with an additional $1,000 "catch-up" contribution allowed for savers age 50 or older. It's also important to note that these are total contribution limits per person, not just per account. In other words, if you have more than one IRA, your total contributions to all of your accounts cannot exceed these limits.

Since Roth IRAs are intended for low- to moderate-income taxpayers, the ability to contribute to a Roth IRA is subject to income limitations. For the 2016 and 2017 tax year, here are the thresholds. If your adjusted gross income (AGI) is below the lower limit for your filing status, you can make a full Roth IRA contribution. And if your AGI falls within the range, you can still make a partial contribution.

Data source: IRS.

If you can't contribute directly, there is a "backdoor" method of using a Roth IRA, which essentially consists of contributing to a traditional IRA and immediately converting the account to a Roth. Here's a discussion of how this works if you're interested.

Other benefits

In addition to the tax benefits, there are a few other benefits to Roth IRAs that are worth mentioning.

• With a Roth IRA, you are free to withdraw your original contributions at any time, for any reason, without penalty. This makes a Roth IRA a smart choice for investors who don't necessarily want their money tied up until retirement. However, your investment profits generally cannot be withdrawn until you reach 59 1/2 years of age.
• Unlike traditional IRAs, Roth IRAs have no required minimum distributions after age 70 1/2. You are free to let your money grow as long as you'd like, which makes Roth IRAs popular tools for estate-planning purposes. A Roth IRA can help you set up your heirs with tax-free income for life.
• Similarly, there is no maximum age to contribute to a Roth IRA. Traditional IRA contributions cannot be made after the account owner turns 70 1/2, but Roth contributions can be made for as long as the contributor has earned income.

Just how much could a Roth IRA save you?

As I mentioned, the current IRS rules allow you to contribute up to $5,500 annually to an IRA, with an additional $1,000 catch-up contribution allowed if you're 50 or older. If you contribute this amount to a traditional IRA, this can result in a tax deduction of, well, $5,500 or $6,500 per year. If you're in the 25% tax bracket, this translates to an annual tax savings of up to $1,625.

On the other hand, let's say that you contribute $5,500 per year to a Roth IRA and that your investments generate average total returns of 8% per year (the market's historic average is about 9.5%, so this is actually a conservative estimate). If you contribute this amount every year for 30 years, so $165,000 total, this rate of return would produce an account value of about $623,000, all of which could be withdrawn tax-free after you reach 59 1/2 years of age.

This would represent a total investment profit of about $458,000. Assuming you're in the 25% tax bracket at retirement, this translates to tax savings of $114,500.

Of course, this is a simplified example. Most IRA investors wouldn't simply withdraw their entire nest egg at once, and there is no way of knowing what the tax brackets will look like when you retire. Additionally, it's important to point out that the overall tax benefits are theoretically the same for both types of IRAs. However, a Roth IRA essentially lets you lock in your current tax rate and not worry about the IRS touching your retirement nest egg.

If you're ready to get started, The Motley Fool's IRA Center can help you choose a broker and learn more about how these accounts work.

OK, so I'll start putting money in a Roth IRA. Then what?

Whenever I start explaining the tax benefits of Roth IRA investing to friends, this is the most common thing they say next. And it's a very good question.

With your Roth IRA, you are free to invest in virtually any stock, bond, mutual fund, or ETF that you want. While this is a nice freedom to have, it's understandably intimidating to many new investors. Fortunately, Roth IRA investing doesn't need to be complicated if you don't want it to be.

A good place to start is with a low-cost S&P 500 ETF like Vanguard's version I discussed in this article. In fact, Warren Buffett has said this is the single best investment that most people can make. Other index funds can be used to form a nice base while you're learning about investing. Then, over time as you get more comfortable and knowledgeable, you can begin to add some individual stocks into the mix.

The bottom line is that the most important thing is to get started as soon as you can. Your investment dollars will never again have the long-term compounding power they do right now, so take advantage.