A Roth IRA can provide a lot of advantages in retirement, but if you're not spreading your savings around to other accounts, you're probably missing out.
Many savers prefer Roth accounts because distributions don't count toward your taxable income in retirement. That can save you money on taxes with proper planning.
But it's not a free ride. To receive that benefit, you must pay taxes on contributions to a Roth account today. And that cost may outweigh the benefits in retirement sometimes.
In fact, if you're only saving for retirement with a Roth IRA, you're probably missing out on big potential tax savings.
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A better tax-free account
As mentioned, with a Roth IRA you pay the taxes up front and then you don't have to worry about taxes in retirement. On the other hand, a traditional IRA or 401(k) can provide you a tax deduction today in exchange for paying taxes on your distributions in retirement. Roth IRAs are recommended for someone in a low tax bracket today.
But you might be able to contribute some money to your traditional IRA or 401(k), take the tax deduction today, and still pay no taxes when you take distributions in retirement.
That's because you can take the standard deduction on your taxes. In 2023, the standard deduction is $13,850 for individuals and $27,700 for married couples filing jointly. That means the first $13,850 (or $27,700) you withdraw from a traditional retirement account in retirement comes with a tax liability of $0, assuming you have no other income.
Sure, $13,850 isn't enough to live on, but the principal idea is that at least some of your withdrawals come out from a traditional IRA tax-free. So you pay no taxes on the contribution and you pay no taxes on the distribution.
That's a heck of a lot better than a Roth, where it's very unlikely you'll pay $0 in taxes on the amount you contribute to your account.
A more flexible tax-free account
You may be able to get Roth-like benefits from a regular taxable brokerage account with the added benefit of flexibility.
If you invest in a taxable brokerage account, the big disadvantage over retirement accounts is the need to pay taxes on any dividends and capital gains accrued in the account. If you trade frequently, those taxable events can add up and eat into your investment gains over time. But if you're a long-term buy-and-hold investor, you can probably keep the taxes on the account extremely low, especially if you invest in growth stocks that pay little or no dividends.
The big advantage of a taxable account over a Roth account is that you can access your entire account balance if you need to. While it's ideal to let your balance grow as much as possible and not touch it, sometimes you need extra capital or another investment opportunity arises. Or if you simply want to retire before 59 1/2, you can withdraw as much as you need without worrying about limitations.
Another advantage is the potential to utilize tax-loss harvesting, which involves purposefully selling a security for a loss, and using that loss to write off any capital gains or up to $3,000 per year in regular income. The latter can produce significant tax savings.
Once you retire, you may be able to withdraw both your principal and earnings with no tax liability. That's because long-term capital gains are taxed at a preferred rate. And if your total taxable income remains below $44,625 (or $89,250 for married couples filing jointly) you'll owe $0 on the long-term capital gains.
So a taxable account could be just as good as a Roth account for some investors with the added benefits of flexibility and potential tax-loss harvesting.
Maximize your benefits with all three
While a Roth is a simple strategy to keep your taxes low in retirement, you may be paying a lot in taxes today for that convenience. Smart investors know that using all three -- a pre-tax retirement account, a Roth account, and a taxable account -- can provide the most flexibility and the greatest overall tax savings in retirement.
