When it comes to retirement planning, one account stands out as the best in class to hold your retirement money: the Roth IRA. In many ways, a Roth IRA is the icing on your retirement cake, as it sits at the sweet spot of taxation and flexibility that makes it a wonderful place to hold your financial assets.
Like the sort of icing you put on cake, though, there can be too much of a good thing. Focusing exclusively on Roth IRAs over every other form of retirement savings can lead to a less rewarding retirement due to the tax costs associated with getting money into your Roth IRA. Finding the right balance point is key, and it's one of the reasons a Roth IRA is icing on the retirement cake.
1. Contributions are limited
If you're under age 50, you can only contribute $6,000 per year to your Roth IRA, and if you're 50 and up, that limit becomes $7,000. Even then, there are income limits that restrict direct Roth IRA contributions, starting with those who earn $125,000 (single) or $198,000 (married filing jointly). Earners who are married but file separate returns generally can't contribute, regardless of their income levels.
Those limits make it challenging to build up a big balance inside your Roth IRA during your working years. Still, the balance you do build can provide an incredible foundation for both your retirement and your estate plans. That makes it worthwhile to figure out ways to get what money you can into that a Roth IRA.
2. Money grows tax-free for your entire life
The best part of getting money inside your Roth IRA is that once it's there, it can generally grow completely tax free for the rest of your life. Unlike other retirement account types, you never need to take distributions from a Roth IRA that you fund yourself. And if you do need to spend the money from your Roth IRA, typical retirement distributions can come out of your account with no impact to your taxes or income.
That makes a Roth IRA an incredibly powerful tool. Most other forms of income in retirement can either increase the taxability of your Social Security income or raise the Medicare Part B premiums you have to pay, on top of being directly taxable. That makes every dollar inside a Roth IRA more valuable for a retiree than an equivalent dollar in a traditional IRA or even most money in a standard brokerage account.
3. Money gets contributed from after-tax dollars
One thing to note about Roth IRAs is that you contribute after-tax dollars to those types of accounts. That means that there are situations where it may make sense to contribute to a deductible traditional type retirement account instead of a Roth IRA. This can especially be true if you're a high income earner closer to the end of your career than the beginning of it.
This is because a deduction from contributing to a traditional retirement account reduces your taxes by your marginal tax rate. On the flip side, a taxable distribution in retirement will generally cost you your average tax rate. If you're a higher earner with less time to grow your money until you'll need it again, that may leave your with more total money than a Roth IRA.
4. You can move money to your Roth IRA from other retirement accounts
One of the most powerful features of your Roth IRA is the fact that you can convert money from other retirement accounts into it. That allows for such things as backdoor Roth IRA contributions that let higher earners get money in their Roth IRA even if they earn too much to be able to directly contribute to one.
It also enables you to get money into your Roth IRA after you retire, by moving cash from your other retirement accounts into your Roth. That can be beneficial if you have a substantial balance in traditional-style 401(k) and IRA plans, as withdrawals from those plans can get very expensive. Since withdrawals from your traditional-style plans become mandatory at age 72 and are treated like ordinary income, those withdrawals can drive high tax and Medicare costs for people with large balances.
By converting money from your traditional retirement accounts to your Roth IRA, you do pay taxes on the conversion, but that money can then grow tax-free in your Roth IRA for the rest of your life. Note that you can't convert money that needs to be withdrawn as part of your mandatory distributions, but any amount above that can be converted. Those conversions reduce your future mandatory distributions, since those amounts are based on the year-end balance of your affected accounts.
Can you have your cake and ice it, too?
Thanks to these four factors, a Roth IRA can work better as the icing on your retirement cake than as the entire cake by itself. A smart retirement strategy that leverages your Roth IRA in that manner can help you build a nest egg that gets you to -- and through -- a financially comfortable retirement.
No matter what you do, though, the sooner you get started, the easier it is to save up enough to make that retirement a reality. So put your plans in place now, and improve your chances of letting your Roth IRA be the perfect icing on your best possible retirement cake.