Roth IRAs can help you pay a lower tax rate on your retirement savings. Roth accounts provide tax benefits when funds are withdrawn in retirement. That differs from traditional IRAs where the tax benefits are realized when funds are contributed to the IRA. Here’s a look at how you can increase the value of your Roth IRA.
Try these strategies to maximize the benefits of a Roth IRA:
— Roth IRAs are especially useful for younger retirement savers.
— Aim to take Roth IRA distributions after age 59 1/2 when withdrawals are tax-free and penalty-free.
— Watch out for the five-year holding period.
— Contribute to a Roth IRA in years when you are in a lower tax bracket.
— Invest in a Roth IRA as soon as possible to take advantage of compound interest growth.
[See: 10 Reasons to Save for Retirement in a Roth IRA.]
How Roth IRAs Work
A Roth IRA is an individual retirement account established by the Taxpayer Relief Act in 1997. “Roth IRAs were conceived by Senator William Roth as a way to provide additional tax benefits to investors, while not adding additional tax burdens on Americans,” says Kristina Keck, a vice president at Woodruff Sawyer in San Francisco.
Roth IRAs differ from traditional IRAs in that your contributions to the account are made after-tax. “State taxes, if applicable, and federal taxes are paid at contribution. Contributions grow tax-deferred, and distributions are taken tax-free,” Keck says. “The key takeaway here is that the IRS gets your taxes at contribution. Traditional IRAs are pretax, contributions grow tax-deferred and distributions are taxed in the year they are taken at the ordinary income tax rate. So in this case, the government has to wait to claim your taxes until distribution.”
When you save in a Roth or traditional IRA, you are deciding whether to pay taxes on your retirement savings now or when you withdraw the money in retirement. “Basically, a Roth IRA provides tax benefits in the future, and a traditional IRA provides tax benefits in the year the contribution is made,” says Heather Comella, a certified financial planner at Origin, an employee financial wellness platform, who is based in California.
Roth IRAs Are Especially Advantageous for Young Retirement Savers
Roth IRAs offer the biggest rewards to people who fund them beginning at a young age. “If you are in your 20s, you are most likely in a lower tax bracket,” Keck says. “If a young person were to contribute to a Roth IRA and, for example, is in a 24% tax bracket at the federal level, he or she would pay the 24% tax in the year contributed.”
Those contributions may grow for 30 or 40 years tax-deferred. “If the investor were to grow in their career and income, they may very likely be in a higher tax bracket in retirement,” Keck says. “If the individual were in a 37% tax bracket at retirement, that individual will gain the benefit of decades of compound returns and receive distributions tax-free.”
Had the same person contributed to a traditional IRA in their 20s, their tax burden will be significantly higher in retirement. In that scenario, the retirement saver would have deferred taxes of 24% at the federal level, contributions would grow tax-deferred, but at distribution they would be paying higher taxes of 37%.
[Read: How to Open a Roth IRA.]
Pros of Saving for Retirement in a Roth IRA
Investments in a Roth IRA enjoy tax-free growth, and distributions generally may be taken after age 59 1/2 tax-free and penalty-free. There are also no minimum distribution requirements, so an investor can leave the money in this account long-term to continue to grow tax-free.
Cons of Saving for Retirement in a Roth IRA
A five-year holding period applies to contributions in order for withdrawals to be tax-free. “If the five-year period is not met, the earnings will be subject to taxes,” Comella says. Also, you may not be eligible to contribute to a Roth IRA if you earn too much. “There are income limitations for who is eligible to make a Roth IRA contribution,” Comella says.
Invest in a Roth IRA as Soon as Possible
The optimal Roth IRA strategy is to contribute to an account as soon as possible, and to do so while you are in a lower tax bracket. “This will give you a longer runway for compound growth of your account,” Keck says. “Additionally, make sure that, if you’re married, you make a contribution for your spouse. The IRS allows for a spouse to establish a Roth IRA even if he or she is not working.”
Use Roth IRA Funds to Help Family Members
Roth IRAs can be useful in estate planning if there is a possibility you won’t need the money in retirement. “In this case, your beneficiary will receive the account and not be hit with a tax bill,” Keck says.
Roth IRAs can also be a good education savings vehicle, as retirement savers may take distributions for certain educational purposes. “They can do so as long as the account has been established for at least five years,” Keck says.
Consider a Roth IRA Conversion
If you’ve already saved significant funds in a traditional IRA, it’s not too late to benefit from a Roth IRA. You may be able to convert part of the funds in a traditional IRA to a Roth if you are willing to pay income tax on the amount converted.
One strategy for Roth IRA conversions is to “fill up” comparatively low income tax brackets with the amount you convert. “Often the best time to accomplish this is just after someone retires, but before they begin mandatory distributions from their IRA,” says John Roessler, a senior financial planner at Kovitz, a Chicago-based financial planning firm. “In this situation, Roth IRA holders can liquidate assets with long-term capital gains to fund living expenses at relatively low tax rates and fill up the low ordinary tax brackets with Roth conversion funds.”
[Read: IRA Contribution Limits for 2022.]
Generate Tax-Free Wealth
Roth IRAs work well for retirement savers because they allow you to pay taxes on IRA contributions now, but then withdraw them tax-free in retirement. “This means that your money is working for you, growing and compounding over time, rather than sitting in Uncle Sam’s pocket,” says Brian Greenberg, chief executive officer at Insurist, a financial services provider based in Scottsdale, Arizona.
To gain the maximum benefits from a Roth IRA, contribute as much as you can to your Roth IRA every year, up to the annual limit. Even small contributions can grow to a significant amount over time. For example, if you contribute $6,000 per year to a Roth IRA over three years in your early 60s and the account grows at an average rate of 7% per year, the balance could grow to be worth over $29,000 by age 70. “That’s a huge difference in how much money you’ll have saved for retirement,” Greenberg says.
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Roth IRA Investment Strategies to Maximize Tax-Free Wealth originally appeared on usnews.com
