8 Reasons a Roth IRA Is Your Future Self's Best Friend

A Roth IRA can be an incredibly powerful tool for planning and financing your retirement. It has a particularly strong combination of features that make it well suited to help you meet your long-term financial goals.

Indeed, for the eight reasons we will discuss, a Roth IRA may very well become your future self’s best friend, at least from a financial perspective. It simply has that much going for it when it comes to being a flexible and valuable part of your overall lifetime financial plan.

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Once your money is inside your Roth IRA, it will grow in a tax-deferred manner for you for the rest of your life. Unless you engage in a prohibited transaction, contribute beyond the limits you’re allowed, or own a partnership that generates UBTI (unrelated business taxable income), taxes aren’t due on money that stays within the plan.

This can be incredibly powerful if you start funding your Roth IRA early in your working career. If you’re able to contribute the full $6,000 as an 18-year-old, for instance, that single contribution could potentially grow to somewhere in the neighborhood of $700,000 by the time you retire. Add that to all the money you can potentially stuff into your Roth IRA over your career, and that tax-deferred growth can really provide a solid leg up on your retirement.

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On top of that tax-deferred compounding, once you’ve reached age 59 1/2 and have had money inside your Roth IRA account for at least five years, money you withdraw from the account comes out tax-free. That means no matter how large your Roth IRA gets, you can tap it for retirement and never pay a dime in income or capital gains taxes on the growth of that money.

That makes every dollar inside your Roth IRA more valuable than any dollar you have outside your Roth IRA, at least once you reach the stage of being able to make those qualified withdrawals. After all, in a traditional IRA, withdrawals are typically taxed at your ordinary income tax rates, and in an ordinary investing account, you’d owe taxes on any gains or dividends you receive.

Unlike other qualified retirement accounts, Roth IRAs are not subject to required minimum distributions during the original account holder’s lifetime. That means the money you accumulate inside your Roth IRA can stay there for the rest of your life.

That may not seem like a huge benefit to you now, but if you accumulate a decently large balance inside your retirement accounts, it can make a gigantic difference in the costs you face as a retiree. Your Medicare Part B premiums, taxes on your Social Security benefits, and the overall taxes you face on your income can grow quite large because of those required distributions.

As those distributions and the taxes and costs they generate are based on simply moving money from one of your pockets to another, it’d be really nice to have a decent chunk of money that avoids them.

In large part because of those required minimum distributions, one strategy that many retirees do is to start converting money from other retirement accounts into their Roth IRAs. The thought process behind that is that by paying some taxes now, they can avoid paying even more taxes and facing higher costs later.

After all, money inside your IRA can continue to grow and compound, even after you’ve retired. For instance, the $50,000 you convert at age 63 could be worth $250,000 or so at age 80. That’s a decent chunk of money that, once converted, will never be subject to those required distributions.

Note that once you are subject to those required distributions, the amount that must be distributed cannot be rolled into a Roth IRA. Any money above and beyond those required distributions can be rolled into your Roth IRA, however, and thus be free from those distributions for the rest of your life.

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The ability to convert money into your Roth IRA from other retirement accounts allows for something commonly known as a backdoor Roth IRA contribution. If your income is too high to directly contribute to a Roth IRA, you can instead contribute to a traditional IRA and then convert the contribution amount to your Roth IRA.

Limits to your ability to directly contribute to a Roth IRA start at around $125,000 of income if you’re single, $198,000 if you’re married filing jointly, or almost immediately if you’re married filing separately. Those limits make it worthwhile for higher-income earners to consider using the backdoor method to get money into their Roth IRAs.

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Money you directly contribute to a Roth IRA can be withdrawn at any time for any reason without tax or penalty. This can be useful if you want to retire early or if you have another need to access your money before a standard retirement age.

The thing to remember, though, is that your Roth IRA direct contributions are currently limited to $6,000 per year if you’re under age 50 or $7,000 per year if you’re 50 or older. That puts a cap on the amount you can pull from your Roth IRA under this provision.

Taking that money out of your Roth IRA also reduces the amount in the account that compounds potentially tax-free for your future. As a result, you should use this feature only if you’re ready to retire early or have a substantial need that can’t be reasonably filled any other way.

Potentially more interesting for people looking to retire early is a technique commonly known as a Roth IRA ladder. This technique takes advantage of the fact that rollover contributions to your Roth IRA can be withdrawn without tax or penalty after that money has been in your Roth IRA for at least five years. Since 401(k) plans have larger contribution limits and often have employer matches, most people have larger balances in their 401(k)s (or similar employer-sponsored plans) than in their Roth IRAs.

With this technique, you roll money from your 401(k) to your Roth IRA and pay any conversion taxes needed on that rollover. You then let that money sit for five years, and you can then pull the converted money out of your account free from any additional taxes or penalties. If you plan far enough ahead or have enough money in after-tax accounts to cover the waiting period, this technique can go a long way toward helping you cover your costs if you retire early.

In addition to the benefits from Roth IRAs not requiring annual distributions, qualified distributions from Roth IRAs aren’t considered as income at all. That helps you keep your taxes down and enables you to better qualify for benefits that are income dependent, while still giving you access to your money when you need it.

This is an incredibly powerful benefit of Roth IRAs, as it works to make all your money that much more valuable. After all, the U.S. tax system is progressive, and the higher your income, the larger the tax rate you pay. You can balance your withdrawal strategies across your traditional retirement accounts, capital gains (and losses) from your ordinary investing accounts, and Roth IRA distributions. By doing so, you can maximize the amount of your money you can both keep and use throughout your lifetime.

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As long as you have an earned income or money in an existing qualified retirement account, you have a path to get some of your assets inside a Roth IRA of your own. The sooner you start taking advantage of it, the longer it can work on your behalf to get you to and through your retirement.

So take a good look at your current financial position, and figure out if at least one of these eight reasons is good enough to make a Roth IRA part of your financial plan. If you make it happen, your future self just might thank you for the introduction to the best financial friend you’ll ever have.

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