Most of us need to accumulate a significant war chest for retirement that can produce much-needed income to supplement Social Security checks. It's smart to devise a retirement plan early -- and to consider making a Roth IRA a part of it.
A Roth IRA offers some meaningful tax advantages. For example, your contributions will grow over time and your withdrawals in retirement can be free of federal taxes! Withdrawals from a traditional IRA are taxed as ordinary income in federal and state taxes. Let's take a closer look at how IRAs (especially Roth IRAs) can strengthen your future financial security and eventually provide valuable retirement income.
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Traditional and Roth IRAs can enhance your retirement
Let's first review just what IRAs are and how they work. There are two main kinds of IRAs -- the traditional IRA and the Roth IRA. With a traditional IRA, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes, too. (Taxable income of $75,000 and a $5,000 contribution? You'll only report $70,000 in taxable income for the year.) The money grows in your account and is taxed at your ordinary income tax rate when you withdraw it in retirement. Many of us will be in lower tax brackets in retirement, so not only is our taxation postponed, but it's often reduced. That's the tax break you get with a traditional IRA.
A Roth IRA has the potential to be much more powerful than that. You contribute post-tax money to a Roth IRA, meaning that your taxable income isn't reduced at all in the contribution year. (Taxable income of $75,000 and a $5,000 contribution? Your taxable income remains $75,000 for the year.) Here's why the Roth IRA is a big deal, though: If you follow the rules, your money grows in the account until you withdraw it in retirement -- when it's yours free of taxes.
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A secondary Roth IRA tax benefit
Another distinction between the two kinds of IRAs is that traditional IRAs feature required minimum distributions (RMDs) that must start once you turn 70 1/2. Fail to take them on time and in the correct amount and you can face stiff penalties. Roth IRAs, though, don't feature RMDs. (But note -- if you inherit any kind of IRA, you'll likely face RMDs.)
These RMDs can be more than just a headache, forcing you to take money out of your IRA when you may not want or need to. They will clearly change your reported income for the year, and they may kick you into the next tax bracket. If you move that RMD money into your regular taxable brokerage account, then as it grows and generates gains, those will be taxable, too.
Thus, the fact that the Roth doesn't compel you to take RMDs is another tax plus.
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Maximize your future financial security
So how much can you sock away in an IRA? Well, IRA contribution limits for 2017 are $5,500, plus an extra $1,000 "catch-up" contribution for those age 50 or older, letting those folks sock away as much as $6,500 for the year.
For best results when saving for retirement with an IRA, contribute as much as you can -- and as soon as you can. The longer your money has to grow, the more it can grow. Sure, sending in any amount can help build a nest egg for retirement. But you can build a bigger and better one by maxing out your contributions.
For example, imagine that you contribute $4,500 every year for 25 years to an IRA and it grows at 10% annually. That will grow to nearly $487,000 -- which is pretty good. But if you contribute $5,500 annually (just $1,000 more) and it all grows at 10% per year, the end result will be $595,000 – a difference of $108,000! Of course, as the annual contribution limits rise each year, you should aim to keep contributing more, ending up with an even bigger nest egg. The table below shows how much money you can accumulate with annual $5,500 contributions at different average annual rates of growth:
|
Growing for |
Growing at 8% |
Growing at 10% |
Growing at 12% |
|---|---|---|---|
|
15 years |
$161,284 |
$192,224 |
$229,643 |
|
20 years |
$271,826 |
$346,514 |
$443,843 |
|
25 years |
$434,239 |
$595,000 |
$821,337 |
|
30 years |
$672,900 |
$995,189 |
$1.5 million |
Source: Calculations by author.
Note, too, that if you accumulated the amounts above, they would be taxable income to you if they were in a traditional IRA, but would be all yours with no taxes due if they were in a Roth. Yes, your original contributions were made with taxed dollars -- but all that growth is tax-free, if you follow the rules.
The tax benefits of a Roth IRA make it a very compelling candidate for your retirement plan -- especially if your retirement is far in the future, giving your money a lot of time to grow.
