You need to save money for retirement so you're not reliant on Social Security later in life. There, I said it, and it's true.
The average monthly Social Security benefit today for retired workers is $1,915.26. Can you live on that? Maybe. Can you live comfortably on that? Probably not. So it's best to have savings to supplement your Social Security income.
When it comes to finding a home for your savings, you have choices. And you may be drawn to a traditional IRA because it could give you an immediate tax break on the money you put in. But a Roth IRA could be a much better bet -- one that sets you up for serious benefits once your retirement kicks off.
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It's worth it for the tax savings alone
Contributions made to a traditional IRA are tax-free up to the annual limit set by the IRS. This year, that limit is $7,000 if you're under the age of 50 or $8,000 if you're 50 or older.
A Roth IRA, on the other hand, gives you no immediate tax incentive. But the tax benefit you might enjoy down the line makes this account more than worth it.
Roth IRA withdrawals come out of your account tax-free. That means that once you're retired, you won't have to worry about the IRS taking a portion of that income. There's also the potential for huge overall tax savings when you choose a Roth IRA.
We know what IRS tax brackets look like today. But we don't know what they'll look like 10, 20, or 30 years from now.
Let's say you contribute $7,000 to a Roth IRA today and fall into the 22% tax bracket, based on your income. Conceivably, you're giving up $1,540 in tax savings by not putting that money into a traditional IRA.
But what if, come retirement, you're in a 30% tax bracket -- whether due to your income or a general change in the tax code? In that case, a $7,000 withdrawal taken tax-free will save you $2,100, which is more than the forgone $1,540 in tax savings you may be looking at now.
Don't forget those tax-free gains
Let's not gloss over the fact that Roth IRAs allow your money to grow completely tax-free. That's an equally, if not more important, benefit.
If you put $500 a month into a Roth IRA over 30 years that generates an average annual 8% return, which is a bit below the stock market's average, you could end up with a portfolio worth about $680,000. Meanwhile, you'll only be contributing $180,000 from your own earnings. So all told, you're potentially looking at a $500,000 gain on which you don't have to pay a dime to the IRS.
There's the flexibility factor to consider, too
Another key feature of Roth IRAs is that they don't impose required minimum distributions (RMDs), whereas traditional IRAs do. That's huge because it not only gives you more leeway for managing your savings, but could also make it possible for your money to grow tax-free for longer.
Let's say you're 73, which is the current age to start RMDs. With a traditional IRA, maybe you're required to remove $10,000 -- and pay taxes on that sum. With a Roth IRA, that requirement doesn't exist. So not only are you saving money by not having to pay a tax bill on a withdrawal you don't want to take, but you're also getting a continued opportunity to keep your $10,000 invested.
All told, a Roth IRA could work wonders for your retirement finances, so it pays to consider making it your go-to retirement account. If you don't qualify for direct contributions due to having a higher income, you could always fund a traditional IRA and then do a Roth IRA conversion.
