How nice would it be to not have to work for a living? It’s never too early (or too late, for that matter) to start thinking about saving for retirement. In fact, the earlier you start, the earlier you can retire (or the wealthier you’ll be when you finally do). The Roth IRA is one of the best deals in investing, and if you qualify, you should absolutely have one.
You’ve probably heard about Roth IRAs (Individual Retirement Accounts) before—especially since financial experts seem to be obsessed with it. And with good reason—it’s a pretty awesome deal if you start saving early.
Note that a Roth IRA is different from a traditional IRA. We’ve run down the different types of IRAs here, but the most common options are the Traditional and Roth. The differences between the two can get a little complicated, but it basically boils down to this:
- The Traditional IRA is tax-deferred. You can deduct the money you save in it each year from your income, meaning you won’t pay as much income tax now. However, when it comes time to withdraw the money at retirement, you’ll pay taxes then.
- The Roth IRA offers tax-free growth. You can’t deduct your savings from your income like you can with a Traditional IRA, but when you withdraw the money at retirement, you don’t have to pay taxes—you’ve already paid.
That tax-free growth is one reason so many experts and individual investors alike rave about the Roth, but it isn’t the only thing that makes it great. Let’s take a closer look at each of its advantages.
Your Money Grows Tax-Free
When deciding between a Roth or Traditional IRA, here’s the general rule of thumb: if you think you’ll be in a higher tax bracket when you retire, go with a Roth. You’ll pay taxes now, but at a lower rate since you’re potentially in a lower bracket.
In a Roth, the money you earn from investing is tax-free, too, assuming you’re withdrawing those earnings at retirement. For this reason, the Roth is especially beneficial if you get in while you’re young or at the beginning of your career. Your money has more time to grow, and since you’ll be at a higher tax bracket when you retire, you’re getting more for your money by paying taxes now. Plus, there are certain income limits for funding a Roth. Once you start earning more than $116,000, you can only contribute a limited amount. You might as well get in and start saving while you’re eligible.
The Roth’s tax advantage also helps you hedge against future tax hikes. There’s no way to know for sure if the federal tax rate will rise in the future, but if that happens, you’ve already paid taxes at the lower rate with your Roth.
You Get More Access to Your Money
When you have a Traditional IRA, you can withdraw contributions early without paying a penalty, but only for a few specific reasons, like buying your first home. Of course, you’ll still have to pay taxes on that money since it was deferred.
On the other hand, with a Roth IRA, you don’t need a special reason to withdraw your contributions: you can withdraw the money you’ve contributed whenever you want (you can’t withdraw the earnings, but you can withdraw as much money as you’ve directly contributed). There’s no penalty, and you won’t have to pay taxes (you’ve already paid them!) This liquidity can be a big perk.
For example, let’s say you’ve always wanted to live in another country, so you’re saving up for a potential relocation. You’re not sure when you’ll need the money, or even if you’ll need it (maybe you’ll find a job there), but either way, you want to save up for a potential move within the next five years. This is a medium to long-term goal, and it might make sense to save in a taxable investment account so you can earn a decent return. However, a better idea might be to save that money in your Roth IRA. This way, you get the return of investing plus you get the tax advantage, plus it’s penalty-free if you do decide to move and need to take the money out. You don’t get to do that with a Traditional IRA.
It’s not a good idea to borrow from your retirement, but this wouldn’t be borrowing: it’s simply storing your savings for a non-retirement goal in your Roth. if you’re looking for a place to save money for a goal, a Roth account is a liquid, tax-advantaged option.
You Might Qualify for the Saver’s Credit
There’s another tax-related perk to the Roth IRA: a little something called the “Saver’s Credit.” It’s a tax break for low to moderate income taxpayers who also have a Roth IRA. Depending on your income, you can use the credit for up to 50 percent of the first $2,000 you save in your IRA. Thus, you can claim up to $1,000 on your tax bill.
One caveat to keep in mind, though: this is a “non-refundable credit,” meaning, it will deduct your owed tax up to zero, but you won’t get a refund. Second, there are income limits. Here are the thresholds for 2015, according to the IRS:
Many taxpayers aren’t aware of this credit. Granted, if you’re earning a moderate to low income, you may not be in a position to save much for retirement. But if you qualify and you can afford to sock away at least a little money, it’s a big perk to consider.
There’s No Required Minimum Distribution
With most retirement accounts, when you reach a certain age, you’re required to take out a specific amount of money. This is called a required minimum distribution, or RMD. Problem is, you might not need all that money, and withdrawing it means you’ll have to pay taxes on that withdrawal. This can push some people into a higher tax bracket.
Not a problem with the Roth IRA, which doesn’t include a required minimum distribution. You have the flexibility to take out however much (or little) money you want each year.
What’s a Backdoor Roth IRA?
Not everyone fully qualifies for a Roth, though. For 2015, you can save up to $5,500 in your Roth, as long as you earn less than $116,000 ($183,000 for married filing jointly). That’s the general contribution limit: $5,500. However, that limit drops incrementally if you earn between $116,000 and $131,000 ($183,000 to $193,000 for married filing jointly).
There is a way to get around this though: it’s called the Backdoor Roth IRA. With this technique, you fund a traditional IRA, then convert it into a Roth. For now, there are no income limits for converting, so you can fund a Roth that way. There are a few mistakes you can make with the backdoor method, and Morningstar runs down some potential snags. However, if you’re careful and you follow the rules, it’s a perfectly legal way to fund an IRA when your income exceeds the threshold.
The Roth IRA is popular for a reason: it comes with a ton of great perks. That said, a Traditional IRA still comes with tax advantages, too, and the tax-deferred perk is a big one. If you’re saving up for a big purchase in the near future, not paying taxes could help you reach that goal faster.
Either way, the most important thing is that you’re saving for retirement to begin with. There are a handful of perks that come with the Roth, but nothing beats reaching financial independence.
Image by Nick Criscuolo.
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