The earlier you start contributing to a Roth IRA, the more it will help your retirement plan. However, many people don't take full advantage of this retirement account's tax benefits. Consider the strengths and weaknesses of a Roth IRA, and use these accounts to your advantage as you build a retirement plan.
What makes Roth IRAs so great
Roth IRAs offer special tax treatment for the gains you accrue on the investments within them. Eligible investors can contribute a certain amount of their after-tax earnings to these accounts annually. Unlike contributions to a traditional IRA or 401(k), those contributions won't reduce your taxable income in the year you make them.
However, the Roth IRA sets itself apart when the time comes to spend down your retirement savings. All the returns that you've amassed over the years can be withdrawn without any taxation. Distributions from qualified accounts like 401(k)s are subject to ordinary income tax. Distributions from normal brokerage accounts are subject to capital gains taxes as positions are closed. This means that Roths are optimized for high-upside investments, such as growth stocks.
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Assets in Roth IRAs are also more flexible than other retirement accounts. Because contributions are made post-tax, they can be withdrawn early without any penalty or tax. That's a lot more flexible than the rules for accessing funds in a 401(k) before you turn 59 1/2, which can include paying tax along with potential penalties. Obviously, you want to avoid making early withdrawals from retirement accounts, but flexibility is a useful feature, as unexpected expenses do pop up throughout life.
Taxes can take a significant bite out of your retirement cash flows if you don't plan appropriately. Investors who use Roth IRAs the right way will enjoy a more balanced tax situation in retirement. It's always helpful to have multiple options for retirement cash withdrawals so that you can pick the most advantageous one at any given time.
Are Roths underutilized?
Americans hold more than $10 trillion in IRAs, but Roths account for less than $1.5 trillion of those assets. Only one-third of investors with IRAs have a Roth account. Those numbers become even more diluted when 401(k) and other employer-sponsored accounts are considered. Roughly $20 trillion worth of assets are held in employer-sponsored plans and pensions. It would seem that people are not utilizing Roths to the full extent they could.
However, the relatively smaller volume of funds being held in Roths can be explained partially by the limitations on these accounts. You can't contribute to a Roth IRA in any year that you make over $153,000 as an individual or that you and your spouse make more than $228,000 if you file taxes jointly. Obviously, this excludes a chunk of the investor population, but more than 90% of U.S. households fall below those income thresholds.
There's also a cap on annual contributions to all of your IRAs, both traditional and Roths -- this year, it's $6,500 ($7,500 for people age 50 or over). Other types of tax-advantaged accounts allow bigger contributions, with 401(k)s allowing for $22,500 in 2023 contributions for those under 50 or $30,000 for those 50 or older. That factor definitely plays a role, too, but it doesn't explain the gap between Roth and traditional IRA balances.
Ultimately, the stats show that lots of people who theoretically could aren't investing via a Roth IRA. This is probably due to financial education and savings habits. An employer-sponsored plan such as a 401(k) requires little effort on the employee's part once they've done the initial setup -- contributions are routed to the accounts automatically with each paycheck. Many people lack the time, confidence, or ability to establish and manage an IRA on their own. Luckily, there are some great resources to simplify the setup and allocation process.
The value of starting early
In general, the earlier you start a Roth IRA, the better. These accounts only outperform the tax-deferred retirement accounts if they deliver enough capital growth. For retirement planning, younger investors tend to focus on growth. Stability and volatility management become more important as you get closer to retirement, so Roths become less valuable as you get older.
Peak earning years are another important consideration. Contributions to a 401(k) or traditional IRA are made pre-tax, and they reduce your taxable income in the year they are made. Those contributions can then grow tax-deferred for years. Most people will occupy lower tax brackets in retirement than they did during their working years, especially during their peak earning years in their 40s and 50s. Many people would gladly pay a lower tax rate on their income a few years down the road. This means that Roths are less valuable -- or even unfavorable -- for many people in the later stages of their careers.
The Roth IRA is optimized for early-career savings for most people. Consider using this tool for your retirement plan while the advantages it offers are still as valuable as possible.
