As you're investing for retirement, one of the best things you can do is make sure you're utilizing all your resources. Tax-advantaged accounts, like 401(k)s or IRAs, are provided to help make saving for retirement more efficient.
When used the right way, a Roth IRA can be a game changer for many people. You get the flexibility of a regular brokerage account but with a much better tax break. Here's how a Roth IRA can save you five figures in retirement.
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How taxes on investments work
The tax rate you pay on investment profits depends on two things: your income and how long you've held the investment. If you hold an investment for a year or less, you'll pay your regular income tax rate on any profits. If you've held the investment for longer than a year, you'll pay the lower long-term capital gains rate.
| Capital Gains Rate | Income Range (Single) | Income Range (Married Filing Jointly) |
|---|---|---|
| 0% | $0 to $40,400 | $0 to $80,800 |
| 15% | $40,401 to $445,850 | $80,801 to $501,600 |
| 20% | $445,851 or more | $501,601 or more |
Data source: IRS.
Although long-term capital gains rates are more favorable than regular income tax rates, it's money owed nonetheless.
It pays to go with a Roth IRA
If you're eligible to contribute to a Roth IRA, you should absolutely do it because it could easily save you five figures in taxes. Let's imagine a scenario where one person invests in a Roth IRA while another invests in a brokerage account. If both people contributed $6,000 annually (the IRA contribution limit if you're under 50 years old) with 10% annual returns, they would have over $590,000 after 25 years.
Since they only personally invested $150,000 during that span, over $440,000 is considered capital gains. In a Roth IRA, it wouldn't quite matter because all withdrawals taken in retirement will be tax-free; you'd receive the whole amount without a penny going to Uncle Sam. However, you'd owe taxes if that money were in a brokerage account. Even at the 15% capital gains rate, that's around $66,000 owed.
This is on the conservative end, too. It's not far-fetched for someone to accumulate over $1 million in investments through their career. In fact, that amount of money is becoming a requirement for many people to live comfortably in retirement. A 15% tax hit on $1 million or more in capital gains will easily put your tax bill into six figures throughout your retirement.
You'll be thankful you used a Roth IRA
Any money spent on taxes is money that's not being spent to enjoy your retirement, regardless of the amount. Roth IRAs are essentially brokerage accounts with tax benefits, so if you're investing for retirement -- which you should -- it makes sense to take advantage and save yourself money on the back end. Ideally, you would contribute the max allowed into your Roth IRA and then return to your regular brokerage account.
Considering Roth IRAs have income limits for eligibility, you may find that one day you're outearning the limit. Before you get to that point, make all the contributions you can. Even if you only contribute $6,000 for one year and put it into an S&P 500 index fund, that amount can easily 10x in 25 years with 10% annual returns. The difference, however, is that in a Roth IRA, that money is all yours. You'll be thanking yourself later.
