Want to help minimize taxes and maximize retirement savings? A Roth IRA, with its tax-free growth potential and tax-free withdrawals for you and your heirs is a way for some investors to do just that (as long as certain requirements are met)1. And those are just two of the benefits of a Roth IRA. There are more that may be less well known.
"We believe most investors should consider having a Roth IRA as part of their overall retirement plan," says Ken Hevert, vice president of retirement products at Fidelity. "And that’s either by contributing to one or converting to one. Besides tax-free withdrawals, a Roth IRA also offers flexibility, doesn't require distributions when you reach a certain age, and can benefit your heirs."
Before we delve into the reasons to consider a Roth IRA, here’s an important note. Not everyone can contribute to a Roth IRA because there are IRS-imposed income limits. But you still may be able to have one by converting existing money in a traditional IRA or other retirement savings account. See "You earn too much to contribute," below.
1. Money can grow tax free. Withdrawals are tax free, too.
You contribute money that's already been taxed (after-tax dollars) to a Roth IRA. There’s no tax deduction on the front end, as there can be with a traditional IRA. But any growth or earnings from the investments in the account—and money you take out in retirement—is free from federal taxes (and usually state and local taxes too), with a few conditions. Withdrawals from Roth IRAs are federal income tax free and penalty free if a five-year "aging" period has been met (a withdrawal is made after a five-year period, beginning with the first taxable year after a contribution to any Roth IRA was made) and the account owner is age 59½ or over, disabled, or deceased (there’s also a $10,000 exception for first-time homebuyers).
Those eligible can contribute $5,500 to a Roth IRA in 2013, or $6,500 if age 50 or older.
2. No minimum required distributions
Roth IRAs do not impose minimum required distributions (MRDs) during the lifetime of the original owner. Traditional IRAs and generally 401(k), 403(b), and other employer-sponsored retirement savings plans do. If you don’t need your distributions for essential expenses, MRDs may be a nuisance. They have to be calculated each year, may result in taxable income, and if you miss taking one, a big penalty as well—50% of the MRD not taken. Because a Roth IRA will eliminate the need to take MRDs, it may also allow you to pass more of your retirement savings onto your heirs (see below).
3. Tax-free money for heirs
In many cases, a Roth IRA has legacy and estate planning benefits, but you need to consider carefully the pros and cons—they can be subtle and complex. Be sure to consult an attorney or estate planning expert before attempting to use Roth accounts as part of an estate plan.
For instance, if you’re planning to leave your retirement savings to your heirs, consider how it may potentially impact their taxes. MRDs from inherited traditional IRAs generate taxable income for heirs, often during their peak earning years, which could unintentionally push them into a higher marginal tax bracket. On the other hand, if your heirs’ combined federal and state income tax rates are expected to be lower than yours, depending on the situation, they may be better off inheriting a traditional IRA rather than a Roth IRA. This may sound counterintuitive, since the heir would not have to pay taxes on distributions from the Roth IRA, but you should consider the total tax cost, including income taxes paid by both parties as well as any applicable estate taxes—not just the income taxes paid by the heir. Also, note that while MRDs are required for inherited Roth IRAs, those distributions generally remain tax free.
Since Roth IRAs don’t require MRDs during your lifetime, these accounts could potentially grow larger over the years for your heirs. And because you pay the income taxes due up front, a Roth IRA conversion may also help reduce the size of your taxable estate. However, be aware that if you’re planning to leave assets to charity rather than to your heirs, conversion to a Roth IRA has the potential to be disadvantageous. This is because in many cases IRAs can be left to a charity directly, without any tax liability to either the IRA owner or the charity. In such cases, conversion would incur taxes that could be avoided.
4. Tax flexibility in retirement
You’ve already paid the taxes on the money in a Roth IRA, so as long as you follow the rules, you get to take your money out tax free. Mixing how you take withdrawals between your traditional qualified accounts and Roth IRAs may allow you to help better manage your overall income tax liability in retirement. You could, for example, take withdrawals from a traditional IRA up to the top of a tax bracket, and then take any money you need above that from a Roth IRA. "This opportunity for tax diversification is one reason why we believe most investors should at least consider having a Roth IRA as part of their overall retirement," says Hevert.
5. Help reduce or even avoid the new Medicare surtax
A Roth IRA may potentially help limit your exposure to the new Medicare surtax on net investment income. That’s because qualified withdrawals from a Roth IRA don’t count toward the modified adjusted gross income (MAGI) threshold that determines the surtax. MRDs from traditional (i.e., pretax) workplace retirement plans, such as a traditional 401(k) or traditional IRA, are included in MAGI and do count toward the MAGI threshold for the tax. Depending on your income in retirement, MRDs could expose you to the Medicare surtax.
6. Hedge against future tax hikes
Federal tax rates rose in 2013 for those with taxable income above $400,000, or $450,000 for couples. Will they rise further in the future? There’s no way to know for certain, but the top tax rate remains far below its historical highs, and if you think it might go up again, a Roth IRA may make sense.
7. Use your contributions at any time
A Roth IRA allows you to take out 100% of what you have contributed at any time and for any reason, with no taxes or penalties. It is only earnings in the Roth IRA that are subject to restrictions on withdrawals. (As noted above, a distribution of earnings from a Roth IRA is tax free and penalty free if and only if the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, die, become disabled, or make a qualified first-time home purchase.) Generally, withdrawals are considered to come from contributions first, and distributions of earnings—which can be taxable if the conditions are not met—begin only when all contributions have been withdrawn.
8. If you’re older, you can continue to contribute as long as you work
As long as you have earned compensation, whether it is a regular paycheck or 1099 income for contract work, you can contribute to a Roth IRA—no matter how old you are. There is no age requirement for contributions, as there is for a traditional IRA, where you cannot contribute if you are older than age 70½—even if you have earned income.
9. If you’re young, your income is likely to rise
The younger you are, the more of a chance your income will be higher when you retire. For instance, if you’re under age 30, it’s likely that your income and spending, even during retirement, will be significantly higher than what it is now, at the beginning of your career. And the greater the difference between your income now and your income in retirement, the more advantageous a Roth account can be.
You earn too much to contribute
In order to contribute to a Roth IRA, you must have employment compensation, and then there are income limits. In 2013, the limit for single filers is income up to $112,000 for a full contribution; $112,000 to $127,000 for partial contributions. For joint filers, the 2013 limit is income up to $178,000 for a full contribution; $178,000 to $188,000 for a partial contribution. If your income is over these limits, the only way you can take advantage of a Roth IRA’s tax-free withdrawals is by converting money from an existing retirement account such as a traditional IRA.2
A caveat. Although you may be tempted to pay for the costs of a Roth IRA conversion by using proceeds from the qualified account you’re converting, it can reduce the potential benefits of conversion. This is doubly true if you’re not yet 59½, since you may have to pay a 10% withdrawal penalty in addition to regular income taxes.
No matter what your age, since a Roth IRA may improve your tax picture, it makes sense to take the time to see if you would benefit from one, notes Hevert. The key is to discuss your situation with a tax or financial adviser to help you fully assess your situation.