The key advantage to utilizing a Roth Individual Retirement Account (IRA) is that when done properly, your withdrawals in retirement are not taxed. For that reason, it has become the most coveted retirement vehicle there is. Roth IRAs prompt many savers to wonder whether they should either begin contributing to or converting a portion or all of their taxable retirement funds into one. While there is no one-size-fits-all answer and every financial circumstance is different, there are three instances where using a Roth IRA becomes a more obvious choice.
1. Young Savers in Their First 5 Years in the Workforce
For the average young professional with competing financial priorities, the decision whether to save for their eventual retirement or for a potential emergency can seem impossible. They may find themselves asking questions like “What if I need the money tomorrow?” or “Won’t the IRS penalize me since I’m nowhere near retirement age?”
Enter the Roth IRA. It is the only truly flexible retirement account available. This is because a Roth IRA allows individuals to withdraw whatever contributions they make to the account, for any reason, without fear of any taxes or penalties. Keep in mind that exception only applies to contributions made by you and not to any subsequent interest or investment returns earned on those contributions.
A Roth IRA allows contributors to put money away toward emergency savings today, while simultaneously saving for their eventual retirement. The IRS requires that you maintain proof of how much is contributed over the years, so documentation is key.
Our young saver in this situation would be able to make automated, periodic contributions to a Roth IRA at intervals that are most convenient for them — for example, the 1st and 15th of each month. Then at the end of the year, assuming they have not withdrawn money to fund an emergency or any other unexpected occurrences, they can begin investing for the future. When another periodic contribution is made in the next month, the rainy-day fund begins to grow all over again.
2. Savers Who Are Committed to Retiring Earlier Than the “Normal” Retirement Age
When it comes to pensions and other similar retirement income vehicles, the IRS deems the normal retirement age to be 65 years old while the Social Security Administration moves the goal post back even further to 67 years old. Even so, there is a movement among younger savers who are determined to retire sooner than the “normal” age. These young people and the revolution that has ensued are affectionately referred to as the Financial Independence Retire Early — or FIRE — movement.
For followers of FIRE and others like them, early retirement is less of an ‘if’ and more of a ‘when’. However, retiring early poses some unique challenges to younger savers. Namely, the money in a portfolio may need to last for as long as 40 or 50 years. Early retirement is certainly an attainable goal, but it requires some advanced planning when it comes to taxes and income.
For instance, let’s say a 48-year-old has decided that they will retire by age 50. They would be 12 years shy of the minimum social security eligibility age. And even then, at age 62, they could expect to receive a significantly reduced benefit every month.
Regardless of whether you are below the income limits and contribute to a Roth IRA directly or if you utilize the backdoor Roth option, you will certainly want to have access to a tax-advantaged pool of funds in the years leading up to social security eligibility.
3. Retirees with More Than Enough Saved to Last A Lifetime
With the unprecedented amount of growth we have seen in the capital markets over the last decade, it is not uncommon to expect retirees who have been diligent about saving and careful about spending to have accumulated more in retirement assets than they will actually need in their lifetime. However, that does not mean they are in a position to begin executing on any lifetime gifting strategies just yet.
Decisions around converting a traditional IRA to a Roth most commonly focus on retirement planning and a person’s expectations of current and future tax rates. However, savers may not be aware that the Roth IRA can also serve as a vehicle to help them achieve their estate planning goals as well.
Many Americans hold substantial assets in tax-deferred retirement accounts, such as traditional IRAs and workplace retirement plans. Depending on their goals, they may want to think about converting some of those assets to a Roth IRA. Converting some of your retirement assets to a Roth IRA, rather than keeping them in a traditional IRA, can lead to significantly greater wealth accumulation for your beneficiaries down the line.
Since Roth IRAs are not subject to the IRS’s Required Minimum Distribution (RMD) requirements, they may continue to grow unaffected by taxes and ultimately provide their named beneficiaries with a larger gift in the end. By leaving your Roth IRA to heirs, you can provide them with tax-free income for years to come. Just be sure you designate your beneficiaries when you open the account and remember to review them every so often.
Important Additional Points:
Roth IRA contributions are not tax deductible the same way contributions to other retirement accounts are. With that said, you should always consider the tax favorability of your employer-sponsored retirement plan before making any contributions to an IRA of any sort, especially if your company offers any matching funds. Free money is still worth more than tax-free money.
Roth IRAs have eligibility requirements that must be satisfied every tax year that a contribution is made. However, those eligibility rules do not apply to conversions. There is no immediate tax advantage to contributing to a Roth IRA, whereas contributions to a traditional IRA, as long as they are deductible contributions, lower the taxable income of the contributor.
The 5-year rule on Roth IRAs requires you to have established the account for 5 years prior to withdrawing any investment earnings without incurring a penalty.
