If you're saving money for retirement, you've taken an important first step in preparing for your future. But you shouldn't limit yourself to just traditional, tax-deferred IRA and 401(k) accounts. A Roth account can help your retirement income go much further by saving you money in a number of ways, particularly when it comes to taxes.
Roth distributions are tax-free
With a traditional retirement savings account, you get a tax break on the money you put into the account, but there's no break on the money you take out. Roth accounts are the other way around: you don't get a tax break on your contributions, but distributions are totally tax-free.
That may not sound like such a great deal on the face of it, but consider this: once you retire, you'll be limited to whatever income you get from Social Security, your retirement savings accounts, and perhaps a part-time job. Being able to keep all the money that you're taking from your retirement savings accounts (instead of paying a percentage to Uncle Sam) can make the difference between living comfortably in retirement and struggling to make ends meet.
Roth accounts can keep Social Security benefits nontaxable
Social Security benefits are a great deal for retirees, but they're not necessarily a free lunch. Depending on how much taxable income you have during the year, your Social Security benefits may be up to 85% taxable. But as you learned in the previous section, Roth distributions are not taxable income. Thus, if the bulk of your retirement savings are in Roth accounts instead of tax-deferred accounts, it's unlikely that you'll have enough taxable income to reach the Social Security benefit taxation threshold.
Roth accounts are exempt from RMDs
Required minimum distributions are the IRS's way of making sure it can finally get the taxes you owe on the money in your tax-deferred retirement savings accounts. Once you hit age 70 1/2, you'll be required to take at least a certain amount out of your tax-deferred accounts every year; this amount is based on the IRS actuaries' estimate of your lifespan and on how much you have in those accounts. But because you've already paid the taxes on the money in your Roth accounts, there are no RMDs for these accounts. So if you have at least a substantial percentage of your retirement savings inside a Roth account, you have far more control over how much you take in distributions each year. That mean you won't get stuck paying taxes on distributions you didn't even need to take!
Roth accounts can lower your tax bracket
Because Roth distributions don't count toward your total taxable income, they can keep you in a lower tax bracket and thereby reduce the tax rate you pay. Depending on how much total income you have, this can be a substantial savings all by itself.
For example, let's say that you are retired and take $50,000 in distributions one year. Using the 2017 tax brackets, assuming you're single, $50,000 in taxable income would put you in the 25% tax bracket and you'd pay a total of $8,238.75 in federal taxes on your distribution. But if just half that money came from a Roth account, then you'd only have $25,000 in taxable income. That would drop you into the 15% tax bracket and would result in a tax bill of $3,283.75. In other words, you'd save nearly $5,000 in taxes just by having half your money in a Roth account.
But what if I don't have a Roth account?
If you're just a few years from retirement (or perhaps have already retired), it's not too late to enjoy the money-saving benefits of a Roth account. In order to get a sizable chunk of money into your Roth account in a timely manner, you can simply do a Roth conversion. That means taking money out of your tax-deferred retirement accounts and transferring it into a Roth account instead. The only issue with a Roth conversion is that you'll have to pay the income taxes on the money you converted when you turn in that year's tax return. So if you have a lot of money to convert, your best bet is to split it out over several years instead of trying to do it all at once and then getting hit with an enormous tax bill. And if paying all those taxes makes you cringe, just remember that you'll be saving money at the other end of the transaction -- when you need it the most.