What’s So Great About a Roth IRA?

In a recent blog post , I compared saving for retirement to training for a marathon.  In the same way I can’t wake up one morning and decide to run a 26-mile race that day, I can’t wait until my 65th birthday to start saving money for retirement. 

The only way to achieve this long-term goal is to save a little bit of money every year and let it grow over several decades.  Even better, if these funds grow without the burden of paying taxes on the earnings, they will grow into an even larger sum by the time I retire.  This is where tax-advantaged savings vehicles like IRAs come in.

As you may already know, there are two primary types of IRAs: the traditional IRA, which grows tax-deferred, and the Roth IRA, which grows tax-free.  Both are great vehicles to save money toward your retirement goals.  The biggest difference between these two retirement accounts is in when they are taxed.

 The Roth IRA is taxed at the beginning, while the Traditional IRA is taxed at the end of its growth.

You’ll find countless articles that debate the pros and cons of these two types of IRAs and detail which type of account is best for people at each income level and at each stage of their work life.  With perfect information about your future income and future tax rate, you could make a perfect decision about which type of IRA is ideal for your retirement savings.

Obviously, we don’t have perfect information on anything that will happen three to four decades from now, least of all American tax rates.  That’s why I’m a huge advocate of the Roth IRA. 

With a Roth IRA, I pay taxes now based on my current income tax rate and never again.  The benefit of tax-free compounding over several decades means my seemingly small $6,000 annual investment could grow into more than a million dollars well before I need to spend it.  And because I already paid taxes on it, I can tap into these funds tax-free in retirement.

By comparison, if I invest in a Traditional IRA, I save a little on taxes this year, but thirty years from now when I start pulling money out of this account in retirement, I’ll pay taxes on all those earnings.  Investing in a tax-deferred account is like investing part of your money for the benefit of the government.   I’d rather pay the taxes now when I know what my tax rate is than in the future when I have no idea how much of my investment will be taxed before I can use it. 

Four main advantages to contributing to a Roth IRA

There are many advantages of investing in a Roth IRA instead of a Traditional IRA, but for the sake of simplicity, let’s look at the four main advantages of the Roth:

1) Tax-free Growth: You fund your original Roth contribution with after-tax money, but once you invest those funds in the Roth IRA, your money grows tax-free.  When you eventually need these funds in retirement, your withdrawal is free from federal taxes as long as the Roth IRA has been open for at least 5 years and you are at least 59 and a half years old. 

2) Easy Withdrawals: You can withdraw your original investment anytime, for any reason, and it is both federally tax-free and penalty-free.  Your investment earnings are subject to early withdrawal rules and penalties, but you can access your original contributions when and if you need them.

3) No Required Minimum Distributions (RMD): The original owner of a Roth IRA can allow their investment to grow tax-free as long as they’re alive.  Unlike a traditional IRA, the government does not require annual withdraws known as required minimum distributions from a Roth IRA once you reach age 72.   You control when and how much distribution you take from you Roth IRA.

4) Tax Diversification in Retirement: By spreading your savings across different investment account types – taxable, tax deferred and tax-free – you gain greater control of how much income you have to report each year during retirement.  When you have tax-free Roth IRA withdrawals available to balance against your taxable pension, 401(k) and Traditional IRA income, you can directly impact how much of your Social Security income becomes taxable and how much you pay in Medicare premiums. 

Keeping more of your money by paying less in taxes is a vital aspect of financial planning.  A financial planner who understands what is most important to you can help you determine the best course of action to meet your future goals. 

Learn how to access the Roth IRA at any income level through the “backdoor” in my next Waypoints Blog. To learn more about how I help senior military leaders achieve their financial goals, sign up for my Waypoints Newsletter. I promise, no SPAM.