One of the best ways to ensure you're prepared for retirement is by using all of the resources available to you throughout your career to save, particularly with tax-advantaged retirement accounts. These offer the dual benefit of allowing you to invest your money (instead of purely saving) while giving you tax breaks too.
Although there are several types of retirement accounts, they're not all alike -- each has its own benefits for potential users to consider. One of the most underrated choices is a Roth IRA, which can be the perfect source of supplemental income in retirement. You could be missing out if you're not currently using a Roth IRA.
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How does a Roth IRA work?
A Roth IRA is a retirement account that lets you contribute after-tax dollars and receive tax-free withdrawals in retirement. The delayed tax benefit of a Roth IRA separates it from a 401(k) or traditional IRA, which allow you to contribute pre-tax money and potentially deduct your contributions from your taxable income (your tax bill won't appear until you take withdrawals in retirement).
To be eligible for tax-free Roth IRA withdrawals, you must be at least 59 1/2 years old and have had your Roth IRA for five or more 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 Feb. 2023 for tax year 2022, you'd have to wait until January 2027 to make tax-free (and penalty-free) withdrawals.
However, Roth IRA withdrawal rules only apply to your earnings. You can withdraw contributions you make at any time, at any age, without paying a penalty. If you contribute $6,000 one year and need to access $1,000 for an emergency, you could do so. If the $6,000 you contributed earned $1,000 in interest, the maximum you could withdraw without a penalty would still be $6,000.
Just because you can withdraw your contributions doesn't mean you should, though. It's best to avoid withdrawing from your retirement accounts if possible.
The flexibility could make a lot of difference
One drawback of a 401(k) is the limited investment options. 401(k) plan providers typically offer a set menu of mutual funds and ETFs (in some cases, ones with high expense ratios). That isn't the case with a Roth IRA.
A Roth IRA is essentially a brokerage account with a huge tax break. You can invest in any stock, ETF, etc. in a Roth IRA. Having this freedom to invest in nearly anything you want ensures your retirement savings align with and complement your financial goals. Growth, dividend, and value investors alike can allocate their Roth IRA investments however they see fit.
A gift from Uncle Sam in retirement
Being able to have your money compound over a career with tax-free withdrawals is a gift that could effortlessly save you a fortune in retirement.
The maximum contribution to a Roth IRA in 2023 is $6,500 ($7,500 if you're 50 or older). To see the power of tax-free withdrawals, let's assume someone invests $500 monthly and averages 8% annual returns over 25 years. After 25 years, the investment value would be just over $438,600, with around $288,600 being capital gains.
Any single filer making over $41,675 and married people filing jointly making over $83,350 will owe at least 15% on the capital gains. Higher earners could owe 20%. In the above scenario, someone would end up paying about $43,000 to $58,000 in capital gains taxes when they take withdrawals in retirement.
If those same investments happened in a Roth IRA, every dollar would be tax-free.
Unlike a 401(k) or traditional IRA, you don't have to take required minimum distributions. This allows you to continue letting your account (ideally) grow and compound until you're ready to tap into it. Or you could never take withdrawals and pass it on to a beneficiary who can let it compound for up to a decade longer.
Use it while you can
One huge downside 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 generally in your best interest to take advantage of a Roth IRA if you're eligible, because one day you may not be.
The good news is that even if you become ineligible to contribute to a Roth IRA, your existing investments will continue to grow and compound tax-free.
