Nowadays, most people cannot count on Social Security to provide enough income during their retirement years. They will need to think strategically about the types of accounts they will need once they retire and make sure they set themselves up for financial security.
The tax-advantaged retirement accounts generally come in two different setups. The traditional account, such as an individual retirement account (IRA), involves pre-tax income that grows without any tax implications. However, once the money is withdrawn from the account in retirement, you will pay income tax on it. The other primary option is a Roth account, such as a Roth IRA, which involves post-tax money with no tax implications for withdrawals.
The Roth IRA, named after William Roth, was created in 1997. The main advantage of this account is that it allows deposits to grow without any sort of taxation. Also, Roth IRAs have many advantages over traditional accounts. For example, contributions can be made at any age as long as you have earned income, and account holders face no required minimum distributions, which means the IRA can be held indefinitely.
Roth IRAs can be funded via regular or spouse contributions, conversions, rollovers, and transfers. Contributions must be in cash rather than existing securities or assets. The limits to contributions are the same for Roth IRAs as traditional accounts.
Some of the Key Benefits of Opening a Roth IRA
One of the truly unique features of a Roth IRA is access to funds. Account holders have easy access to the contributions they make to a Roth IRA, which is not the case with traditional accounts.
If you put $5,000 in a Roth IRA and the account later grows to a value of $10,000, you can withdraw the initial investment of $5,000 at any time without paying any sort of income tax or penalties. With Roth IRAs, you can always access contributions before tapping into investment gains, which is not possible with a traditional IRA or a 401(k). With these two accounts, withdrawals always trigger income taxes and further penalties depending on age. For this reason, a Roth IRA can provide you with easy access to money and liquidity that is not possible with other retirement accounts.
Many people use Roth IRAs for tax savings while in retirement. Once retired, you can withdraw from both contributions and investment gains without paying any sort of income tax. A Roth IRA does not increase the tax liability or tax rate for retirees, and withdrawals have no impact on Medicare premiums or Social Security taxes. The tax-free nature of the account can help you save money in retirement. For example, if you wanted to purchase a new car in retirement through a traditional account, it would involve paying taxes on the withdrawal on top of sales tax and other fees. If you have the money for the purchase through a Roth IRA, you could save a great deal on tax liability.
The unique tax situation of a Roth IRA can also allow you to save money on taxes in retirement. Think of opening a Roth IRA as diversifying your income options in retirement so you can be more strategic and reduce your tax liability. A Roth IRA can keep you from entering a higher tax bracket and owing more money to the government.
Imagine a year in which Social Security and distributions from tax accounts bring you very close to the line for a higher income tax bracket. For the rest of the year, you could take money only from your Roth IRA, which has no tax implications, and maintain a high quality of life without owing more than expected in taxes.
How to Open and Fund a Roth IRA
A major downside to the Roth IRA is that it is not an employer-sponsored account, so you will need to be proactive about creating an account. However, doing this due diligence is just a limited investment of time. The IRS has permitted brokerage companies, credit unions, loan associations, and banks to offer IRAs. Most people choose to open an IRA with a brokerage.
Also, you can open a Roth IRA at any time, but the contributions for a given tax year must be made before the deadline for filing taxes, which is usually April 15 of the following year. However, you can still contribute to the prior year up until that deadline. Importantly, extensions granted for filing taxes do not apply to Roth IRA contributions.
Choosing the right financial institution is key as not all IRA providers have the same investment options. And while some providers may have many different options, others may be much more restricted.
Furthermore, virtually every institution will have its own fee structure, so it is important to review this information. Fees can have a big impact on the overall returns if they are too high. Investors who like to manage their accounts actively should look for providers with low trading costs, while those who prefer a hands-off approach should make sure there is not an account inactivity fee. Another piece of information to look at is the minimum account balance, which can be high in some cases.