If you are looking for tax-free income and more flexibility during retirement, one option to consider is investing in a Roth IRA. While Roth IRA contributions are not sheltered from current taxes like contributions to traditional IRAs, they do offer other tax benefits during retirement.
The Roth IRA advantage
- Retirement withdrawals (including earnings) are tax-free. As long as you wait to take distributions until you are 59½ or older, the full amount of your Roth account is tax-free.
- Save taxes on other earnings. During retirement, withdrawals from traditional IRAs increase your taxable income. This can bump other earnings into a higher tax bracket and potentially increase the taxability of your Social Security benefits. Conversely, Roth withdrawals are not reported as income, keeping tax rates as low as possible.
- More flexibility during retirement. Once you turn 70½, the IRS requires that you take required minimum distributions (RMDs) from traditional IRAs. If you don’t, you’ll get hit with a 50 percent penalty! There is no such requirement for Roth IRAs. You can leave (and even contribute) funds to grow in the account as long as you want.
- Contributions can be withdrawn tax-free at any age. If you have a financial hardship and need to make an early withdrawal, only the earnings in a Roth are subject to a 10 percent early withdrawal penalty. Meaning, Roth contributions can be withdrawn tax-free and penalty-free at anytime. This is because you use after-tax funds to make your original Roth contributions. This is not the case with traditional IRAs – the full withdrawal is subject to the penalty if you make it before you turn 59½.
The Roth IRA is not for everyone
While there are many reasons to consider contributing to a Roth IRA, they are not for everyone. Here are some factors to consider:
- Income limits. While there are no income limits if you wish to roll funds from other accounts into a Roth IRA, there are income limits to contribute to a Roth IRA. For 2018 they are $135,000 single ($137,000 in 2019) and $199,000 married ($203,000 in 2019).
- 5-year account requirement. To receive the full tax-free benefit of Roth investment earnings, you must have your Roth account for five years before making withdrawals.
- Future tax uncertainty. While no one knows what the future holds, keeping tabs on tax trends is an important aspect of retirement planning. Increasing or decreasing tax rates may ultimately determine the best type of retirement investment for you. In addition, the government has the power to change the taxability of your IRA if they deem it necessary.