Secure Your Financial Future: 7 Compelling Reasons to Start a Roth IRA
In the labyrinth of financial planning, the Roth IRA is a beacon of hope that can illuminate your path to a secure and prosperous retirement. The advantages of a Roth account can significantly impact your financial future. If you haven't considered it, now is the time to pay attention.
#1 Tax-Free Growth
The most appealing feature of Roth is the tax-free growth. Unlike traditional retirement accounts, where contributions are made with pre-tax dollars, Roth contributions are made with after-tax dollars. This means that your investments grow tax-free over time. When you retire and begin withdrawing funds, you won't owe any taxes on the qualified distributions, offering a significant advantage over other retirement accounts. It's always cheaper to pay for the seeds than the harvest.
#2 No Required Minimum Distributions (RMDs)
Roth IRAs doesn't have an RMD when you reach a certain age per the IRS (This number gets pushed back throughout the years). In 2024, the magic number is when you turn 73 years old. A traditional IRA let's you defer taxes, and for most W2 employees, it is best to max that out if you are able to. However, imagine if you have been contributing a hefty amount of your salary over time into your tax deferred IRA (i.e. 401K, 403b, 457b)- when it's time to take them out due to RMD you may be paying Uncle Sam a very large sum of money, because depending on your income at the time, you may be pushed up to a higher tax bracket.
Here is a table from nerd wallet on 2024 Tax Rates for single filers:
Here is a table for Married Filing Jointly:
For example, you are now 73 and your 401K balance is $1million dollars:
Per IRS RMD calculations ->
That's not the worst of it yet. This number usually increases over the years because theoretically your investments increase over time. Here is a ten year projection of how much are you required to withdraw per year for being a diligent 401K contributor using Schwab's calculator. I used an estimate of 8% ROR (rate of return) but know that it fluctuates over time and it's just an estimate.
You may say, well I only have $200,000 in my 401K, it's shouldn't be that much right?
Well, let's check that out...
Paying taxes on an additional income of $7547.17 per year just because you were a diligent saver and lived frugally your whole life doesn't seem like a fair deal.
Here are the payments projected over 10 years...
At 82 years old, expect to pay taxes on an extra $14,841.87 of your income on top of your social security and maybe even a pension (for those who have pensions). You potentially increase your tax bracket over time. There's a myth floating around that you lower your tax bracket when you retire, but that is simply not always true. Especially if you have investments and assets that are continually appreciating.
#3 Diversify Your Tax Exposure
Diversification is not just about spreading your investments across different assets; it's also about diversifying your tax exposure. By contributing to both traditional and Roth retirement accounts, you create a tax-diversified portfolio. This strategy allows you to manage your tax liability strategically in retirement, giving you greater control over your income streams and potentially minimizing your tax burden.
#4 Access to a Wide Range of Investment Options
You have a wide variety to choose from: Mutual Funds, Exchange Traded Funds (ETFs), Stocks, Bonds, you name it. Since a Roth IRA isn't provided by an employer, the investment options are not restricted, as opposed to a Roth 401K (we will talk more about that in another article).
#5 Estate Planning Benefits
Roth accounts offer valuable estate planning benefits. Upon your passing, your Roth IRA can be passed on to your heirs, who can then enjoy tax-free distributions over their lifetimes (depending on the situation). This feature can be a powerful wealth-building tool for future generations and can play a crucial role in creating a lasting financial legacy.
#6 Limitations
- IRS limits high-income earners from contributing to a Roth IRA account. If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $153,000 for tax year 2023 and $161,000 for tax year 2024 to contribute to a Roth IRA, and if you're married and file jointly, your MAGI must be under $228,000 for tax year 2023 and $240,000 for tax year 2024.
- If you inherit a Roth IRA, you may be subject to RMDs, and these distributions cannot be rolled over into another retirement account. See image below per IRS website.
- If you're saving for education expenses and plan to apply for financial aid, money in a Roth IRA may be considered as part of your assets, potentially affecting your eligibility for need-based financial aid.
- Know the "5-year Rule of Roth" - If you withdraw earnings from your Roth IRA within the first five years of opening the account, you may be subject to income taxes and 10% penalties, even if you are over 59½ years old.
- Contributions to Roth IRAs do not provide an upfront tax break. While earnings grow tax-free, you don't receive the benefit of tax deferral on your contributions.
- Contribution limits per year are small compared to 401Ks. For 2024, maximum contribution is $7000, or $8000 if you are at least 50 years old.
#7 Loopholes
- Have you heard of the backdoor Roth conversion? It is a strategy utilized by high income earning individuals to contribute to a Roth even though their income exceeds the limits set by the IRS. You can convert the funds you've contributed from your Traditional IRA into your Roth IRA. You will have to pay taxes on this conversion. Depending on your tax liabilities, you can calculate how much you are willing to convert on a year to year basis. This strategy will lower the amount you will need to withdraw later on when you hit RMD age therefore saving you from paying more taxes.
- Caveat, if you're a W2 employee, you cannot do a regular backdoor Roth conversion until you have left your company. It is best to do this right when you leave the company so as not to keep it growing tax-deferred and paying higher taxes later. Remember that it's always cheaper to pay for seeds than the harvest.
- If you think that's pretty amazing, then get ready for the MEGA Backdoor Roth conversion. You need to be part of an employer-sponsored retirement plan (401 k or 457 b etc) that allows after-tax contributions. Be aware of the overall contribution limits set by the IRS. Call your workplace financial representative to clarify how much after tax contribution you can rollover then convert into your Roth IRA while currently employed. Each workplace may have different rules on how they accomplish this. Some will only allow a rollover from their after tax contributions to their 403 or 457 deferred Roth to be done if they are 59.5 years old or they have separated from that employer. Some plans allow after tax contributions that can be rolled over into your Roth IRA at any age even while you are still employed by them. Before pulling the trigger, please consult your financial representative at work and or a licensed professional.
Check out the IRS webpage on IRAs to keep up with the latest information by clicking here.
Tax laws can change, and future legislative changes could potentially impact the Roth IRA's favorable tax treatment. It's essential to stay informed about any changes in tax regulations. Consult with a tax professional to ensure compliance and understand the specific implications for your financial situation.
Have you started one yet? Let me know in the comments!
