Roth IRAs have many great advantages.
Today’s article will discuss the benefits and reasons why you should invest in a Roth IRA. This is the first part of a two-part series. An article next Monday will discuss the many different ways you can fund a Roth IRA.
Traditional IRAs became available in 1974 and were praised for their benefits of tax deferral. As long as you contribute to a contribution for 401 (k), 403 (b) or a traditional IRA, the money you pay is not taxed as income that year. This is why your contributions are called pre-tax.
Money grows without taxes until retirement and you have to withdraw funds. Investors were also told they would likely be in the lower tax bracket when they retire.
Ah, but there’s the kick! When you withdraw funds from a traditional IRA, all money (your contributions, plus earnings over the years) is 100% taxable as income in the year you withdraw it. But many retirees are not in the lower tax bracket than they were while working. Traditional IRAs just “throw the bucket down the road,” requiring you to pay taxes later.
In my opinion, traditional IRAs are not wonderful. The tax deferral is nice – until you start taking payments, and all payments are taxable as income. (There is no preferential tax rate on withdrawals from traditional IRAs.)
Taxation at retirement can also cause social security benefits to be taxed at a higher rate. Another negative feature is that if you leave your traditional IRA to your spouse – or children or grandchildren – they will pay taxes when withdrawing money. The IRS insists that someone will pay taxes after those years of tax deferral. That is inevitable. As they say, “Nothing is safe except death and taxes.”
Roth IRA
to help
Roth IRAs became available in 1998. They are one of the largest gifts Congress has given to investors in more than 25 years. Let’s look at the advantages:
Withdrawals are tax-free: When you contribute to a Roth IRA – or a Roth 401 (k) or 403 (b) – you invest money that is taxed as income that year. However, when you withdraw money (possibly many years later), the contributions and all earnings over many years are tax-free; 100% tax free.
You can access your contributions at any time: Suppose you are 40 years old and you contribute $ 6,000 to the Roth IRA for eight years a year. Your account grows from $ 48,000 invested to $ 80,000 after eight years. You can withdraw your contributions (up to $ 48,000) at any time without penalty. Contributions are available to you as needed. This is because these contributions were “after tax”. Earnings have limits on when they can be withdrawn, but not contributions.
Roth IRAs do not have the necessary minimum distributions like traditional IRAs. Traditional IRAs require you to start taking withdrawal funds by age 72 (current retirees have started at age 70.5, but the age has recently increased). The required minimum allocations (RMDs) are determined by the tax administration chart, which usually starts at approximately 3.7% in the first year and increases each year as you age. These RMDs are fully taxable in the year in which they are withdrawn. Roth IRAs do not have RMDs, which allows the investor to allow money to grow and become more complicated for many years to come.
Roth IRAs can keep your income tax rate lower in retirement: Because RMDs are not required of Roth’s IRAs (as is the case with traditional IRAs), and withdrawals from Roth’s IRAs during retirement are tax-free, your income tax may remain at a lower rate, thus minimizing taxes on your social security benefits.
Roth IRAs are not taxed if left to children or grandchildren – unlike traditional IRAs. The negative feature of former President Donald Trump’s tax changes that took effect on January 1, 2020 (called “Safe Law”) will negatively affect users who are not married to traditional IRAs and Roth’s IRAs. Instead of allowing a “stretch” (withdrawal over the life of the beneficiary), the funds must now be withdrawn within 10 years of the death of the original owner. For traditional IRAs, the beneficiary must pay a withdrawal tax. For inherited Roth IRAs, withdrawals are not taxed. (Note that spouse’s beneficiaries will continue to receive a “stretch”. Unmarried beneficiaries must follow the 10-year rule).
Roth IRAs are a great tool for real estate planning: For many years, investors were able to bequeath their taxable account to a spouse, children or grandchildren, and the beneficiary received a “reinforcement” based on the value of the property on the day of death. President Joe Biden has proposed that this benefit be discontinued for wealthy investors. Since Roth IRAs are not taxable for the user, they are not threatened by any new rules that would remove the basis for the increase.
Roth IRAs are great for teens and 20s: Although the Roth IRA is primarily a retirement tool, it is also powerful for young people because of the many years it has to account for tax exemptions. To contribute to Roth IRAs, a person must have “earned income” on a tax return (this eliminates young children and most retirees). For teens, the income earned could be from a part-time job.
Parents and grandparents can contribute on behalf of the young person: Suppose a teenager or student has more than $ 6,000 in earned income. A parent or grandparent can pay $ 6,000 into a Roth IRA owned by a young person. You will help your child or grandchild start financial security. As already mentioned, a young person can withdraw contributions at any time without penalties and taxes for any reason, such as a down payment for a house or to start a small business. Or the entire amount can be left for retirement, where there are more than 40 years to grow and complicate.
The Roth IRA is an important tool in the investor toolbox. With the abolition of traditional pensions and the debate over the future of social security, most young people feel that the safety nets provided to past generations of Americans are disappearing. On top of that, tax rates are likely to increase. Building a significant Roth IRA without taxes is wise. I strongly encourage you to take advantage of the many benefits of the Roth IRA !.
As a note, when I wrote about Roth’s IRAs in the early 2000s, there were always skeptics who predicted that Roth’s IRAs would lose their tax-free status. That hasn’t happened in 23 years. Can that happen? Yes. Is it likely? I don’t think so. There have been reports that if tax breaks were reduced, the old Roth IRAs would probably be “old” under the old rules.
There are many ways to build a Roth IRA, and that will be the topic next week.
Donna Skeels Cygan, CFP, MBA, is the author of The Joy of Financial Security. She has been a financial planner only for fees in Albuquerque for more than 20 years, and is the head of a subsidiary of Mercer Advisors in New Mexico. Contact her at [email protected].
