Among the various retirement tools available to the American public, the Roth IRA is unquestionably the best.
Compared to an employer-sponsored 401(k), which has a contribution limit of $18,000 for those aged 49 and under in 2016 and $24,000 for those aged 50 and up, the Roth IRA's contribution limit of $5,500 and $6,500 for those same age ranges may seem a bit boring. However, unlike Traditional IRAs and 401(k)s, which are tax-deferred investment tools that require the accountholder to pay tax when withdrawing money during retirement, a Roth IRA's investment gains grow tax-free for life. It's this difference, among a few other benefits, that allows the Roth IRA to often stand head-and-shoulders above competing investment vehicles.
The big question is whether or not you should open and contribute to a Roth IRA. For some people that may not be the best idea. But in certain situations, contributing to a Roth IRA makes perfect sense. Here are six such situations.
1. If you're young
One of the smartest reasons to contribute to a Roth IRA is if you're young and have multiple decades left in your working career. Chances are that as you age and gain work experience your income will grow as well, potentially putting you into a higher marginal tax bracket. This is where the Roth IRA comes into play.
Since distributions from a Roth are tax-free, they won't count toward your income during retirement. In other words, no matter how much you withdraw from a Roth, it won't push you into a higher tax bracket during your golden years. If you expect to be in a higher tax bracket by the time you hit your 60s and 70s than you are in your 20s and 30s, which is not uncommon assuming your salary and tax-deferred investment accounts grow over time, then a Roth IRA could be a great idea.
2. If you expect Congress to raise tax rates
Another good reason to consider contributing to a Roth IRA is if you expect lawmakers on Capitol Hill to increase tax rates in the future.
To be crystal clear, no one has the slightest clue what Congress is going to do with tax rates, so it's really anyone's guess. However, the peak marginal income tax rates between 1982 and 1986 were 50%, and between 1932 and 1980 they were at least 70%, if not higher. Our current peak marginal income tax rates are well below their historic average, and it's always possible that a debt-riddled U.S. Congress could seek to boost revenue with across-the-board tax hikes. Thus, contributing to a Roth IRA and making use of its tax-free status could offer a nice hedge against an uncertain tax future.
3. If you want financial flexibility (or just hate RMDs)
A third situation where opening a Roth IRA would make a lot of sense is if you crave financial flexibility with your retirement money.
One of the biggest possible drawbacks of Traditional IRAs and 401(k)s is the attached required minimum distribution, or RMD. Both of these tax-deferred plans require accountholders to begin taking withdrawals by age 70-1/2 at the latest; the RMD is the dollar amount they're required to withdraw by December 31 each year. Some seniors simply have no need for an annual distribution, and it could wind up thrusting them into a higher tax bracket.
Enter the Roth IRA, which has no RMD attached. If seniors choose, they can let their Roth IRAs continue to grow for as long as they'd like without taking out a cent. Likewise, withdrawals can be made in any increment since they'll have no effect on modified adjusted gross income.
4. If you want to avoid the Medicare surtax and/or taxes on Social Security benefits
If the thought of paying a Medicare surtax and/or tax on your Social Security benefits during retirement makes you cringe, then a Roth IRA could be the answer.
Whether you realize it or not, Medicare hits individuals and couples earning more than $85,000 and $170,000, respectively, with a surcharge to their monthly premiums for Part B (outpatient services) and Part D (prescription drug coverage). The IRS also levies taxes on a portion of your Social Security benefits if individual income exceeds $25,000, or $32,000 if you're a joint-filer.
A Roth IRA offers a potentially straightforward solution to these taxes, since Roth IRA income doesn't count toward your adjusted gross income. If taking withdrawals from a Roth can help keep your AGI below $85,000 as an individual or $170,000 as a couple, you could save money by not paying the Medicare surtax. Similarly, if a Roth IRA is a big part of your retirement planning with few other alternative income sources, you may be able to avoid paying tax on any of your Social Security benefits. Over time these tax savings can add up.
5. If you want easy access to emergency funds
A fifth reason you might consider a Roth IRA as a smart retirement option is if you want access to your cash in case of an emergency.
In theory, all Americans should have an emergency fund with enough money to cover six months or more of expenses. In reality, most Americans don't have anywhere near this much saved for an emergency. One of the greatest aspects of a Roth IRA, which builds upon the financial flexibility discussed in point three, is that since contributions are made with after-tax dollars, they can be removed by the accountholder at any time, for any reason, without penalty or tax.
For example, assume you contributed $50,000 over the course of 10 years, and your account was worth $100,000 at the end of that 10-year mark. If an emergency arose and you didn't have enough in a savings account, you'd be able to access up to your original $50,000 contribution without any penalty or tax.
6. If you want to leave tax-free money to your heirs
Finally, a Roth could be a wise option if you're looking to pass along tax-free money to your family or friends upon your passing.
If you likely won't need the funds from a Roth IRA during your lifetime, it may be worthwhile to name beneficiaries to your Roth and pass along your wealth to the next generation. This way your assets could really benefit from time and compounding and set your children, grandchildren, or anyone else you had in mind up for a nice head start.
One thing you'll want to keep in mind with inherited Roth IRAs is that inherited Roths do have RMDs attached, though they're almost always tax-free. The beneficiary of an inherited Roth IRA has the opportunity to take RMDs over the course of their life expectancy, which is often the best option since it allows the existing assets to continue to compound, or they can take the entirety of the account's balance by Dec. 31 of the fifth year of the prior accountholder's passing. If the heir doesn't, there could be a 50% penalty attached. But if done right, a Roth IRA can be an invaluable gift to your heirs.
If you've decided that opening a Roth IRA is the right move for you, here is a place where you can compare IRA providers.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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