An Individual Retirement Account also known as an IRA is an account that allows you to save for your retirement. There are two main types of IRAs: Traditional IRA and Roth IRA. They both offer tax advantages but do differ when investing and withdrawing your money.
Contributions to a Traditional IRA are characteristically tax-deductible the year you contribute to them. Qualified withdrawals from your Roth IRA (in retirement and on other certain occasions) are not taxes. The type of IRA you contribute to will be determined by your personal situation. It’s worthwhile to speak to a tax professional to discuss which IRA is best for you. In this article, we will talk about the advantages of a Roth IRA.
Tax Advantages of a Roth IRA
You won’t see tax breaks now when you contribute to a Roth IRA. However, you will get a tax break in the future, as Roth earnings and withdrawals are generally tax-free. Contributions to a Roth IRA are made after your income is taxed. Since you have already paid taxes on this money, you do not need to pay them again when you withdraw funds. Your earnings will build tax free!
Younger earners who contribute to a Roth IRA have a bit more tax advantage benefits. The plan is that your salary will increase as you age which means that your tax bracket will also increase. The benefit to paying taxes now is that your income could be at a higher rate in the future.
Roth IRA as an Emergency Fund
When life happens, your Roth IRA can provide additional emergency funds. Your contributions (not your earnings) can be withdrawn tax-free and penalty-free if you meet certain criteria. For example, if your account has not been open for five tax years, withdrawals of account earnings are subject to income tax and early withdrawal penalties (unless your emergency is a qualifying event such as becoming permanently disabled). Keep in mind that many emergency financial situations, such as a job loss, are often accompanied with a market downturn, meaning your Roth IRA may be worth less when withdrawing funds. Plus, you will be surrendering years and potentially decades of tax-free growth. Still, knowing you have your Roth IRA as a backup emergency fund if you truly need it can provide peace of mind.
Use a Roth IRA to Fund Your First Home
You may use your contributions and up to $10,000 of earnings to buy your first home (or to gift your child/grandchild money for their first home). This is a tax-free withdrawal. First time home buyers can use this money if the account has been open for five years and if the funds will be used directly toward the home purchase. The amount includes the down payment and closing costs. If the funds do not go directly to the home purchase, the earnings will be taxed and you will incur a 10 percent penalty.
If you are young and just starting out saving in a Roth IRA, it is only recommended doing this if you have already set aside this Roth IRA for the purpose of purchasing a home. If you are planning to use this money for retirement, you could wipe out a large contribution that would otherwise grow through years of compounding interest.
Fund Your College Education
Besides contributing to a 529 college savings plan, which are state operated tax-advantaged accounts used to pay for qualified college expenses, you may choose to set up a Roth IRA to pay for these expenses. The Roth IRA can pay qualified educational expenses for you, your spouse, your child or your grandchild. Withdrawals of your contributions for qualified educational expenses are tax free. Examples of qualified educational expenses are tuition, fees and other related expenses for an eligible student that are required for enrollment or attendance at an eligible educational institution. However, earnings withdrawals are subject to tax. It’s important that the funds go directly toward educational expenses. If they are used for anything else, you will pay a 10 percent penalty.
Taxes in Retirement
First thing to remember is that your contributions to a Roth IRA are made after income taxes. This means you do not have to pay taxes when you withdraw those contributions. A Roth IRA give you the flexibility to manage your taxable income during retirement by potentially reducing your income taxes. Economists predict that income taxes will rise. If that is the case, then you will be saving money on taxes with a Roth IRA. Consult your tax, financial or estate planning advisors about how you may reduce your taxable income in retirement.
Your Heirs: Tax-Free Income
One of the valuable estate planning tools is a Roth IRA especially if you have a substantial amount in your savings and do not need all of it to for your retirement. The beneficiaries of your Roth IRA do not need to pay income taxes on their withdrawals (unless your estate is subject to estate taxes). What a great gift to leave your loved ones. Again, consult your tax, financial or estate planning advisor on how to achieve your wishes.
To sum up, the major pros of a Roth IRA:
- Tax Benefits
- Tax-free growth: Your contributions and earning grow tax-free
- Tax-free withdrawals: Withdrawals during retirement are tax-free.
- No tax penalty for qualified withdrawals: You can withdraw your original contributions at any time without taxes or penalties.
- Flexibility
- Flexible access to your money: You can withdraw any amount you add to your Roth without taxes or penalties, anytime for any reason.
- No required minimum distributions: You don’t have to withdraw money during market downturns.
- Wealth Transfer
- Ideal wealth transfer vehicles – Because there are no required minimum distributions, your Roth IRA could potentially grow larger over the years for your heirs.
- Inherited Roth IRAs are tax-free – If you pass your Roth IRA onto your heirs, their withdrawals of contributions are tax free.
This information is not intended to be a substitute for specific personalized tax or legal advice. We always suggest that you discuss your specific circumstances with a qualified tax or legal advisor.
