If you're investing for retirement this year, you'll need to decide what kind of tax-advantaged retirement plan to use.
Depending on your income and what type of plan your employer offers, if any, you may have a few options, including a traditional 401(k) or IRA or a Roth 401(k) or IRA.
While there are pros and cons to each, there are three really good reasons why you may want to opt for a Roth IRA this year and beyond.
1. Tax rates are probably going up
President Joe Biden has pledged not to raise taxes on individuals with incomes under $400,000. And with ongoing conflict over whether any tax increases should occur at all, there's a very good chance that no one will see their taxes go up any time soon.
But the reality is that most people who are years away from retirement are likely to see their tax rate rise before they reach the point where they leave the workforce. That's because tax rates are very low by historical averages, as this table below from the Congressional Budget Office shows. And an aging population, rising government debt, and broad support for an expansion of entitlement programs is likely to make these low rates unsustainable over the long term.
If you expect your tax rate will be higher as a retiree than when you are working and investing, you're better off with a Roth account. But if you anticipate the reverse, a traditional IRA is better. This is because of the disparate tax treatment of these two accounts.
With a Roth IRA, you don't get to claim a tax deduction for the contributions you make each year. Instead, you get to take tax-free withdrawals. If your tax rate is higher later when you're making withdrawals than when you're contributing to your account, deferring your tax savings just makes sense.
With a traditional account, you do get an upfront deduction so you save in the year you contribute. However, withdrawals are taxed. So if you think you'll pay a lower rate later, it's better to pay taxes as a retiree at your future lower rate and save now.
While many people assume their income will fall in retirement, thus lowering their rate in the future, this math doesn't necessarily add up if the federal government substantially raises rates for everyone. If that happens, which it likely will, a Roth IRA will probably be the best choice for most future retirees.
2. You might avoid future taxes on Social Security benefits
A Roth IRA won't just allow you to avoid taxes on retirement account withdrawals. It can also protect your Social Security benefits from the IRS.
Social Security benefits become partly taxable after provisional income exceeds $25,000 for single tax filers and $32,000 for married joint filers. These thresholds aren't indexed to inflation. And because of wage growth that naturally occurs over time, more seniors are subject to the tax every single year. That will continue to be the case unless Congress takes the unlikely step of changing this rule that's been in place for decades.
However, remember that provisional income is not the same as total income. Instead, provisional income that determines the taxability of Social Security is calculated by taking into account your:
- Taxable income
- Half your Social Security benefits
- Some nontaxable income, such as municipal bond interest.
Roth distributions, however, aren't taxable and aren't added back into provisional income. So if you are getting your retirement money from a Roth IRA, none of it counts, and you're unlikely to hit those thresholds where you lose part of your Social Security checks to the government.
3. You won't have to worry about required minimum distributions
Finally, Roth IRAs benefit you in one more key way: They provide more flexibility as to when you can take out money.
Most tax-advantaged retirement accounts mandate you take required minimum distributions (RMDs) on a schedule determined by the IRS starting at age 72. In other words, the government tells you when and how much you must take out of your retirement accounts. And you have to listen, even if you don't need that much money.
If you don't want the IRS dictating a minimum withdrawal from your investment accounts each year, a Roth IRA is the account for you.
For all of these reasons, you should strongly consider putting your retirement money into a Roth IRA this year, after maxing out any employer match available to you in your 401(k). When you enjoy lower taxes and more freedom as a senior, you'll be glad you made that choice.