To be as efficient as possible, saving and investing for retirement should be a holistic process. One of the best ways to do so is by taking advantage of retirement accounts that give tax breaks for people stashing money away.
When it comes to retirement accounts, 401(k)s get most of the attention because they're the most common, but they're just one account. A retirement mistake that's all too common is not utilizing an IRA, particularly a Roth IRA. Here's why.
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What exactly is a Roth IRA?
A Roth IRA is a retirement account that lets you contribute after-tax dollars and receive tax-free withdrawals in retirement. This differs from a 401(k) and traditional IRA, which allow you to contribute pre-tax money and potentially deduct your contributions from your taxable income.
The only requirements for receiving tax-free Roth IRA withdrawals are that you must be at least 59 1/2 years old and have had your Roth IRA for five years. This five-year countdown begins on the first day of the tax year of your initial contribution to any Roth IRA. For example, if you opened your first Roth IRA and made your initial contribution in March 2023 for tax year 2022, you'd have to wait until January 2027 to make tax-free (and penalty-free) withdrawals.
Luckily, this rule only applies to the withdrawal of earnings. You can withdraw contributions you make at any time, at any age, without paying a penalty. And since you paid taxes on it before contributing, you won't owe taxes again.
Easily save thousands in capital gains taxes
To see the power of having your investments compound tax-free, let's imagine someone invests $500 monthly and averages 8% annual returns over 30 years. After 30 years, the investment value would be just under $680,000, although they personally invested $180,000 over that span.
Assuming they file as a single taxpayer and have taxable income over $41,675 annually, they'll pay at least 15% on their capital gains. On the high end, it'll be 20%. In this scenario, they could end up paying around $75,000 or $100,000 in taxes when they withdraw their investments in retirement. If those same investments happened in a Roth IRA, every penny would be tax-free.
The amount saved in taxes could be years of retirement income for some people.
Not everyone is eligible to contribute to a Roth IRA
One huge drawback of a Roth IRA is the income limit for eligibility. For tax year 2023, the most you can earn and still be eligible to contribute to a Roth IRA is $153,000 if you're single and $228,000 if you're married and filing jointly.
Given the tax benefits, it's usually in your best interest to take advantage of a Roth IRA if you're eligible, because that may not always be the case.
Even if you eventually become ineligible to contribute to a Roth IRA, your investments will continue to grow and compound tax-free. Let's imagine you become ineligible for a Roth IRA after your account balance is $30,000, for example. If your investments average 8% annual returns for 10 years after that, your account value could be over $64,000.
A scenario where a Roth IRA may not be best (even if you're eligible) is if you expect your tax bracket in retirement to be noticeably lower than your current tax bracket. In that case, it may make sense to contribute to a traditional IRA, take a current tax deduction, and then pay taxes on withdrawals in retirement at a much lower rate.
Ability to pass the account on
Owners of 401(k) and traditional IRA accounts must take required minimum distributions once they turn 73 years old. This isn't the case with a Roth IRA. In fact, you never have to take withdrawals from your Roth IRA if you don't want, allowing you to potentially pass it on to a beneficiary to keep compounding.
In many cases, your beneficiary would have to withdraw the full amount of the Roth IRA by Dec. 31st of the 10th year of receiving it, but that's a lot of time for an account to keep growing. Building on our above example, if a beneficiary received a Roth IRA worth $680,000 and it continued to average 8% annual returns for 10 years, it'd more than double to over $1.4 million.
