Takeaways
- Millions of individuals and families use Roth IRAs to save for retirement.
- Money contributed to a Roth IRA grows tax-free.
- Roth IRA distributions are not taxed (besides for early withdrawal)
- Roth IRAs have a contribution limit of $6,500 for the tax year 2023.
- Savers at least 50 years old can contribute $7,500 for the tax year 2023.
Part of any financial planning should contemplate retirement planning. Roth IRAs can be a critical part of that strategy. There are various retirement accounts to sort through, and selecting the best account to start saving with can become complicated quickly. For many investors, the Individual Retirement Arrangement (IRA) makes perfect financial sense.
The most popular types of Individual Retirement Arrangements are the Roth IRA or the Traditional IRA. Both have their merits, but the Roth IRA is a fantastic place to begin saving for retirement, especially for young professionals.
What is a Roth IRA?
A Roth IRA is a retirement savings account that allows you to contribute post-tax income toward your retirement savings, regardless of whether your employer offers a retirement plan. Roth IRAs are one of the most common retirement savings accounts, especially for young professionals, due to their overall investment flexibility, early phase-outs, and after-tax savings.
Roth IRAs have their Pros and Cons. Consider all of these before deciding to start a Roth IRA account. We believe that incorporating a Roth IRA into your retirement planning is more a question of when rather than if.
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Advantages of a Roth IRA
Here are several advantages of a Roth IRA:
Investment Flexibility
One of the most popular features of the Roth IRA is the flexibility to make investments across a spectrum of assets. You can invest in stocks, ETFs, target date funds, and mutual funds. Not all retirement accounts, like an employee-sponsored 401(k), offer such flexibility.
This flexibility can be great for beginner investors exploring what types of investments they want to make and can encourage long-term investing habits. And for seasoned investors, the Roth IRA allows them to invest in exactly what they want.
Investment Gains Not Taxed
In a Roth IRA, contributions go tax-free. That means when you sell your investments, you don’t pay taxes. This feature is particularly unique and allows you to compound your gains even faster than other types of accounts because you don’t have to pay taxes on those gains, allowing you to redeploy more capital back into new investments
Distributions Not Taxed
Contributions made to your Roth IRA are not tax-deductible. While this feature differs from a Traditional IRA, it allows you to take post-tax money today and trade that for no taxes on your contributions and enjoy tax-free withdrawals in the future.
Roth IRAs are considered best for investors who expect to be in a higher tax bracket later in life when they start taking withdrawals from their Roth IRA account because those withdrawals will be tax-free.
Flexibility on Contribution Timing
The maximum contribution limit for a Roth IRA for the tax year 2023 is $6,500 for those under 50 years old and $7,500 for those 50 years old or older.
But what if you don’t have the maximum contribution limit today? That is not a problem because taxpayers can contribute to a Roth IRA until April of the following tax year. This allows you to sequence your contributions over time or make one lump sum contribution.
For example, if you are saving for your Roth IRA in 2023, you have until April 15, 2024, to reach your contribution limit.
No Penalty for Early Withdrawals of Contributions
While there can be a penalty for early withdrawals of your Roth IRA investment earnings, there is no penalty for early withdrawals of your Roth IRA contributions. Your contributions can always be a source of liquid cash for your financial needs. While it is best to let those funds keep making investments, if you need to withdraw those funds, you can without penalty
Disadvantages of a Roth IRA
Here are several disadvantages of a Roth IRA:
Contributions Are Not Deductible
Unlike Traditional IRAs, Roth IRA contributions are not tax-deductible. This means you must choose to allocate these funds after they have been fully taxed and are competing with other financial opportunities. But if you are saving for retirement, a Roth IRA should take priority in your financial planning.
Early Phase Outs for Contributions
One of the downsides to the Roth IRA is that your contributions are affected by your Modified Adjusted Gross Income or modified AGI. If you make more income, you might be phased out from making Roth IRA contributions.
If you are married and filing jointly or are a qualifying widow(er) and your modified AGI is above $228,000, you are not allowed to contribute to your Roth IRA. When planning to open a Roth IRA, it is vital to consult the full table of the Roth IRA limits to see where you stand. Your contribution eligibility may affect how you plan your contributions and overall retirement planning strategy.
Penalty for Early Withdrawals of Earnings
Withdrawing money early from your Roth IRA could trigger tax penalties. Early withdrawals on earnings, or those occurring before you turn 59 ½ years old and have had less than five years of contributions, are subject to a 10% penalty. While this is certainly a disadvantage, you can withdraw your contributions penalty-free.
However, some IRS exceptions apply. For example, qualified first-time home buyers can take out $10,000, a lifetime limit, to purchase your house.
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Balancing what retirement account to save for – Roth IRA, Traditional IRA, or employee-sponsored 401(k) – is a matter of timing, phase-out limits, tax planning, and personal preference. If you feel like you don’t know where to start, or want to talk with a financial professional, consider getting a financial advisor or robo advisor to help you with financial planning. Starting on the right financial footing can add money to your wallet and set you on the right trajectory.
Smart Summary
Saving for retirement is a smart money move because there is virtually no disadvantage to saving for retirement. While you certainly want to ensure your financial house is in order before contributing to retirement, considering your financial future is a smart habit. Investing early in your professional career will allow you to harness compounding interest. A Roth IRA might be perfect for you.
