Roth IRAs have many great benefits.
Today’s article will discuss the benefits and the reasons you should invest in a Roth IRA. This is part one of a two-part series. Next Monday’s article will discuss many different ways you can fund a Roth IRA.
Traditional IRAs became available in 1974 and were touted for their tax-deferral benefits. You contribute to a 401(k), 403(b), or traditional IRA while you are working, and the money you contribute is not taxed as income that year. This is the reason your contributions are termed pre-tax.
The money grows tax-free until you retire and need to withdraw the funds. Investors were also told they would likely be in a lower tax bracket when they retire.
Ah, but there’s the kicker! When you withdraw funds from a traditional IRA, all the money (your contributions, plus the earnings over the years) is 100% taxable as income in the year you withdraw it. But many retirees are not in a lower tax bracket than while they were working. Traditional IRAs just “kick the bucket down the road,” requiring you to pay the taxes later.
In my view, traditional IRAs are not wonderful. Tax deferral is nice – until you start taking withdrawals, and the withdrawals are all taxable as income. (There is no preferential tax rate on withdrawals from traditional IRAs.)
The taxation during 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 a spouse – or to children or grandchildren – they will pay taxes when they take withdrawals. The IRS insists that someone will pay the taxes after those years of tax-deferral. It is unavoidable. As they say: “Nothing is certain except death and taxes.”
Roth IRAs to the rescue
Roth IRAs became available in 1998. They are one of the greatest gifts Congress has given investors in over 25 years. Let’s review the benefits:
Withdrawals are tax-free: When you contribute to a Roth IRA — or Roth 401(k) or 403(b) — you are investing money that is being taxed as income that year. However, when you withdraw the money (possibly many years later), the contributions and all the earnings over many years are tax-free; 100% tax-free.
You can access your contributions at any time: Let’s assume you are 40 years old, and you contribute $6,000 per year to a Roth IRA for eight years. Your account grows from the $48,000 invested to $80,000 after eight years. You can withdraw your contributions (up to $48,000) at any time without penalties. The contributions are available to you as needed. This is because those contributions were “after-tax.” The earnings have restrictions on when they can be withdrawn, but not the contributions.
Roth IRAs do not have Required Minimum Distributions like traditional IRAs do. Traditional IRAs require you to start taking withdrawals by age 72 (current retirees started at 70.5, but the age was increased recently). The required minimum distributions (RMDs) are determined by an IRS chart that typically starts at approximately 3.7% in year one and increases each year as you get older. These RMDs are fully taxable in the year they are withdrawn. Roth IRAs do not have RMDs, thereby allowing an investor to let the money grow and compound over many more years.
Roth IRAs can keep your income tax rate lower in retirement: Because RMDs are not required from Roth IRAs (as they are with traditional IRAs), and withdrawals from a Roth IRA during retirement are tax-free, your income tax can stay at a lower rate, thereby minimizing the taxes on your Social Security benefits.
Roth IRAs are not taxed when left to children or grandchildren — unlike traditional IRAs. A negative feature of former President Donald Trump’s tax changes effective Jan. 1, 2020, (called “The Secure Act”), will adversely impact nonspouse beneficiaries of traditional IRAs and Roth IRAs. Instead of allowing a “stretch” (withdrawals over the beneficiary’s lifetime), the funds must now be withdrawn within 10 years after the original owner’s death. For traditional IRAs, the beneficiary must pay taxes on the withdrawals. For inherited Roth IRAs, the withdrawals are not taxed. (Note that spousal beneficiaries will still receive the “stretch.” Nonspouse beneficiaries must follow the 10-year rule).
Roth IRAs are an excellent estate planning tool: For many years, investors could bequeath their taxable account to a spouse, children or grandchildren, and the beneficiary received a “step-up” in basis to the asset’s value on the date of death. President Joe Biden has suggested that this benefit should end for wealthy investors. Because Roth IRAs are not taxable to the beneficiary, they are not at risk of any new rules that would eliminate the step-up in basis.
Roth IRAs are great for teenagers and 20-somethings: Although the Roth IRA is primarily a retirement tool, it is also powerful for young people because of the many years they have for the account to compound tax-free. To contribute to a Roth IRA, a person must have “earned income” on a tax return (this eliminates young children and most retirees). For teenagers, the earned income could be from a part-time job.
Parents and grandparents can contribute on behalf of the young person: Let’s assume a teenager or college student has more than $6,000 of earned income. The parent or grandparent can contribute $6,000 to a Roth IRA that is owned by the young person. You will be helping your child or grandchild with a jump-start to financial security. As mentioned before, the contributions can be withdrawn by the young person without penalties or taxes at any time for any reasons, such as a down payment on a home or for starting a small business. Or the full amount can be left for retirement, where it has over 40 years to grow and compound.
The Roth IRA is an important tool in an investor’s tool box. With traditional pensions being eliminated and the future of Social Security being debated, most young people feel like safety nets provided to past generations of Americans are disappearing. On top of that, tax rates will likely increase. Building a significant tax-free Roth IRA is wise. I strongly encourage you to take advantage of the Roth IRA’s many great benefits!.
As a side-note, when I wrote about Roth IRAs in the early 2000s, there were always skeptics that predicted Roth IRAs would lose their tax-free status. This has not happened in 23 years. Could it happen? Yes. Is it likely? I don’t think so. There have been reports that if the tax benefits are reduced, old Roth IRAs would likely be “grandfathered” under the old rules.
There are many ways to build a Roth IRA, and that will be next week’s topic.