Any time you're saving and investing for retirement, it's a good thing. You never hear anybody complaining about being financially overprepared, but you definitely hear the opposite. There are dozens of ways to financially prepare for retirement, but two of the surest ways are by starting early and taking advantage of retirement accounts.
Most people are aware of a 401(k) because it's the most popular retirement account, but a Roth IRA has an especially useful benefit that makes it one of the more attractive options available.
Image source: Getty Images.
Avoiding capital gains taxes can work wonders for retirees
A Roth IRA's tax break is particularly valuable because it happens on the back end in retirement. You contribute after-tax money to your Roth IRA, where it grows tax-free. As long as you're 59 1/2 years old and made your first contribution to the Roth IRA at least five years prior, all withdrawals are tax-free in retirement.
Having your money grow and compound without a tax bill waiting is a benefit that could save you thousands in retirement.
In 2024, the most you can contribute to a Roth IRA is $7,000. If you're 50 or older, you can add a $1,000 catch-up contribution. To see the tax break in action, imagine investing $7,000 annually and averaging 10% annual returns. Here's roughly how much you would have earned after different years.
| Years Invested | Investment Value | Personal Contributions | Capital Gains |
|---|---|---|---|
| 10 | $111,500 | $69,960 | $41,540 |
| 15 | $222,380 | $104,940 | $117,440 |
| 20 | $400,700 | $139,920 | $260,780 |
| 25 | $688,000 | $174,900 | $513,100 |
| 30 | $1.15 million | $209,880 | $940,120 |
Calculations by author. Investment values are rounded to the nearest 10.
The key number to pay attention to here is the capital gains. Capital gains are the profit you make from a stock's appreciation. If you buy a stock for $100 and sell it for $150, you have $50 in capital gains.
Profit aside, paying attention to your capital gains is important because you'll owe capital gains taxes on that amount when you sell stocks -- unless it's in a Roth IRA. In a regular brokerage account, you'd owe taxes on the $41,540 to $940,120 in capital gains from our above example.
In a Roth IRA, the full investment amounts would be yours without a penny owed to Uncle Sam.
Everyone may not be eligible to contribute to a Roth IRA
One of the drawbacks of a Roth IRA is the income limit. In 2024, the most you can earn and still be eligible to contribute to a Roth IRA is $161,000 if you're single and $240,000 if you're married and filing jointly.
Those over the Roth IRA income limit can still take advantage of the account by going the backdoor Roth IRA route. To create a backdoor Roth IRA, you must first contribute to a traditional IRA, which doesn't have income limits. After you've contributed to the traditional IRA, contact your IRA provider to start a conversion to a Roth IRA.
This process varies between plan providers, so consult your plan administrator for specific guidance. If you don't have a Roth IRA already, you'll establish one during the conversion process. It's worth noting that a backdoor Roth IRA isn't an official retirement account but the name given to this particular method of getting a Roth IRA.
It's not a tax evasion strategy, either. If you deduct your traditional IRA contributions and then convert them to a Roth IRA, you will likely have to include the conversion amount as taxable income. Luckily, the deduction for the traditional IRA contribution and the income from the conversion should cancel each other out.
Don't forget other retirement income sources
A Roth IRA is a powerful retirement savings tool, and I encourage any eligible person to take advantage of it. However, because of its relatively low contribution limit, it's better utilized as a supplemental retirement account instead of your only retirement account.
The goal should be to have multiple retirement accounts and retirement income sources. By using a 401(k) if available, IRAs, and sources like Social Security, retirees can make sure they're as financially stable as possible.
