Most investment vehicles don't inspire starry-eyed adoration, but if any are deserving of that kind of attention, it would be the Roth IRA.
The Roth version of the individual retirement account lets investors put away $5,500 in 2016; those over age 50 can put in an extra $1,000 in catch-up contributions. But that's no different from the traditional IRA. The significant differences between the Roth and the traditional IRA hinge on when you pay taxes and how much money ultimately goes to Uncle Sam.
Financial planners routinely say that younger people should invest in a Roth because they would benefit most from its many wonderful qualities. But the truth is, Roth IRAs make a good choice for people of all ages.
6 advantages of Roth IRAs
- You get tax-free income in retirement.
- Roth IRAs offer flexibility.
- You can contribute after age 70 1/2.
- Your heirs benefit.
- High earners have a 'back-door' entry.
- It's probably the best option.
You get tax-free income in retirement
With Roth IRAs, savers get a tax-free stream of income in retirement. And it's not just the contributions that come out tax-free. Uncle Sam doesn't lay a finger on any of the earnings. It can be a pretty sweet deal when you're talking about decades of compounding.
The only catch is that you pay income tax on your contributions upfront.
Unlike the traditional IRA, which gives investors a tax deduction for the year the contribution is made, the Roth version lets savers contribute after-tax money today and withdraw principal and earnings tax-free at retirement.
"For individuals looking for tax diversification in retirement, the Roth IRA is one of the few buckets they can create that ensures that they have a stream of tax-free income in retirement," says Ken Hevert, senior vice president of personal and small business retirement products at Fidelity Investments.
Roth IRAs offer flexibility
Setting up and maintaining an emergency savings account is like filling up a leaky bucket. It's never going to be full, and if you don't pay close attention, it can be emptied quickly.
In a pinch, a Roth IRA could provide some quick cash. That's because Roth contributions can be withdrawn penalty-free at any time.
"When you get into earnings or growth, that's when you're looking at potential income taxes and potentially penalties as well," says Maria Bruno, senior investment analyst with Vanguard's Investment Strategy Group. "We don't encourage that because it really should be a vehicle that's earmarked for retirement. The reality is that it does offer some flexibility."
To take out more than just the contributions, investors must be at least 59 1/2 years old and the account must have been opened for 5 years. But there are some qualified withdrawals if you don't meet the age or holding period requirement.
"One of them is, for instance, a first-time home purchase up to $10,000. Another is postsecondary education expenses," Bruno says.
There are some other circumstances as well, according to the IRS:
- Unreimbursed medical expenses that exceed 10% of adjusted gross income -- 7.5% for those who are 65 or older through the 2016 tax year.
- Back taxes.
- Paying health insurance premiums while unemployed.
You can contribute after age 70 1/2
With a traditional IRA, investors must stop making contributions when they turn 70 1/2 years old, at which point they are forced to take distributions and begin paying taxes on that money.
The Roth IRA has no required minimum distributions. That means you can live to 120 without ever tapping your Roth IRA. Furthermore, anyone with earned income can keep adding to their Roth IRA account regardless of age. If you're earning an income at age 87 and want to save for the future, have at it: You can continue to contribute until you quit working or drop dead, whichever comes first.
"If you're still working, you can contribute," says Bruno.
Your heirs benefit
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The hands-off approach the IRS takes on Roth IRAs is beneficial for your heirs, as well. Savers with ample accounts can leave their beneficiaries tax-free income that can be stretched over their lifetime.
"It allows you to prepay taxes for future generations," says CFP professional Frank Armstrong, principal of Investor Solutions in Miami. "As an estate-planning tool, it's extraordinarily powerful. Grandchildren would receive tax-free income for the rest of their lives; all of the earnings for an extended period of time would be totally tax-free.
"The trade-off is that you pay taxes now on the contribution," he says. But if you anticipate leaving money to kids or grandkids, forgoing the tax break today can give your bequest a boost in the future.
High earners have a 'back-door' entry
High-income earners generally cannot make a contribution to a Roth IRA. The IRS has income thresholds that limit the size of the contribution that high earners can make. Above that threshold, direct contributions to a Roth IRA are disallowed.
But there is a way around that. People who make a lot of money can make a nondeductible contribution to a traditional IRA and then convert it to a Roth.
"It's what we call a back-door Roth. Everybody can do a nondeductible IRA and then convert to a Roth," says Armstrong.
"Up until 2010, there were limitations on who could convert. Now that is one of the options for anyone who had built up assets in a traditional IRA," says Hevert.
However, the IRS does require you to take into consideration all your pretax holdings when figuring the tax liability of a conversion. Because it's complicated, it's best to consult a tax professional before attempting this maneuver.
It's probably the best option
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For people who are looking for relief from today's tax bill, making a contribution to a traditional IRA offers a welcome tax deduction.
"If your tax situation is very high today and you expect it to be lower after you retire, then you want to use a regular IRA or 401(k)," says Armstrong.
But taking advantage of the tax break today leaves many of the valuable benefits of the Roth on the table.
"In most cases our analysis has indicated that if you are eligible and have options, the Roth IRA over time is going to deliver a greater benefit in retirement. The ultimate benefit is in retirement because they are tax-free and can stay in the tax-free account even longer. In all the comparisons, putting money into the tax-free option will typically outweigh the other options," Hevert says.