Roth IRAs are tax-exempt retirement accounts that offer a number of unique features. While your Roth IRA might not solve your entire retirement savings equation, if you decide to make annual contributions over the course of your working life, you'll really reap the benefits when it finally comes time to sunset your career.
Here, we'll discuss how your Roth IRA can offer a ton of tax savings in retirement.
How does a Roth IRA work?
Roth IRAs offer tax-exempt investing space for aspiring retirees. This means you contribute after-tax dollars to your account (up to $6,500 in 2023 for those under 50, up to $7,500 in 2023 for those over 50) and in exchange, never have to pay tax again on any growth or earnings. This is the case as long as you hold the account open for at least five years and don't make any withdrawals until at least age 59.5. In other words, if you use your Roth IRA for retirement expenses, you'll more than likely be able to make qualified tax-free withdrawals.
With regard to tax savings, you won't be taxed on any realized gains within your account (such as if you sell stocks at a gain), and you also won't be taxed as you receive monthly, quarterly, or annual dividend payments. Since you won't be taxed annually on any gains, growth, or earnings, this can help reduce your annual tax bill -- especially when compared to investing in a regular taxable brokerage account. Furthermore, unlike a tax-deferred 401(k), you won't be taxed when you take money out of your account in retirement.
Image source: Getty Images.
The tax benefits of a Roth IRA
Beyond the tax-free nature of the account, the Roth IRA comes with psychological benefits. First, the money in the account is always all yours -- something that can't be said about pre-tax 401(k)s or traditional taxable brokerage accounts. Tax-deferred 401(k)s come with an embedded tax liability (that will hit at points throughout your retirement), and taxable brokerage accounts generate an ongoing tax liability when dividends are paid or capital gains are distributed. The Roth IRA effectively eliminates these tax expenses forever, and that comes with a tremendous mental advantage as it relates to your financial planning.
Critically, Roth IRAs also come without potentially costly required minimum distributions (or "RMDs"). RMDs, when taken from pre-tax or tax-deferred accounts, have the effect of increasing your adjusted gross income -- even to the point of pushing you into higher tax brackets. In other words, RMDs can cause more of your income to be taxed at higher rates, and they can knock you out of being eligible for preferential tax breaks or cause you to have to pay surcharges for Medicare premiums.
These are small details that can become big expenses if you're not careful. But the Roth IRA, as a fully tax-exempt vehicle, does a good job of eliminating these concerns. To the extent you can consistently contribute to a Roth IRA, you'll be spared expensive RMDs and enjoy lower taxable income in retirement.
Commit to annual contributions
If you can commit to maxing out your Roth IRA (or your backdoor Roth IRA, if you fall above the income limits to contribute directly to your Roth), you can secure a significant tax-free retirement nest egg. If you can't max out the account -- by contribute an average of $542 per month for those under 50 -- shoot for a few hundred dollars per month instead. The benefits are clearly there even if it ends up that your Roth IRA doesn't cover all of your retirement costs.
This is not to say you should swear off 401(k) investing entirely, either. The most successful retirees often have a combination of tax-deferred and tax-free retirement accounts (in other words, they're "tax-diversified"). This allows them to manage their ongoing and lifetime tax liabilities by showing higher levels of income in certain years but not others. This is possible if you have money in both pre-tax and after-tax accounts.
As with most financial management decisions, if there are two reasonable choices, try to take a middle road if possible. Contribute to a variety of accounts with a variety of tax statuses, and you'll position yourself well for a lengthy and financially secure retirement.
