Top 5 Benefits of a Roth IRA

Knowing the perks that Roth has over Traditional.


KEY TAKEAWAYS

  • Looking for tax-free income? Roth IRAs can provide it.

  • Having early access to retirement dollars can come in handy.

  • Maintain full control over your retirement distributions.

  • Manage taxes on Social Security and Medicare Part B premiums.

  • Pass on tax-free benefits to loved ones.

As Benjamin Franklin famously said, "Only two things in life are certain: death and taxes."


When it comes to your retirement savings, you have two choices:

  • Traditional (Pre-tax) = Pay taxes in retirement.

  • Roth (Tax-free) = Pay taxes now.


Without a doubt, this choice will determine your overall income tax exposure. But what most people fail to see is that this choice also creates a ripple effect on other key aspects of your retirement plan. When you take a step back and look at the big picture, Roth IRAs can provide a number of financial benefits, and those financial benefits lead to a greater sense of security and peace of mind.


Here are the top five benefits of having a Roth IRA.


Tax-free Retirement Income


The fundamental difference between Traditional and Roth IRAs is when you pay taxes. With Roth IRAs, you already paid taxes at the time of your contributions, so the IRS says thank you and considers its business with you complete. This allows your money to grow completely tax-free until you decide to take it out.


So, imagine Dan and Dana each have $2,000,000 saved for retirement. Dan has all $2,000,000 in traditional, pre-tax savings while Dana has all $2,000,000 in Roth. Who has more security in their retirement? Dan, who still has to pay federal income taxes and has no idea what rates will be in the future? Or Dana, who has no future tax liability and can count on every penny to support her lifestyle?


Flexible, Early Access


Ideally, the money you have saved and invested for retirement should stay there until you need it for retirement. But, in reality, life happens and you may experience a time when you need money and lack options. If you take an early withdrawal from a Traditional IRA before age 59 ½, then you’ll pay ordinary income taxes and a 10% penalty (unless you qualify for a hardship withdrawal).


Not with a Roth IRA. With a Roth IRA, you always have access to the amount you have contributed, tax and penalty-free. So, let’s say that you contributed $25,000 to a Roth IRA that is now worth $75,000. You’re in a pinch and need quick, painless access to cash. You can take up to $25,000 out of the Roth IRA without any taxes or penalties. Even better, you also have 60 days to replenish your Roth IRA if it was a short-term cash crunch.


No RMDs


The IRS is in the business of collecting tax payments, and most people choose to make pre-tax contributions, delaying the IRS from collecting its tax bills until the money is taken out. Well, the IRS will only wait so long until they come knocking to enforce a Required Minimum Distribution (RMD). As the name implies, it’s the minimum amount that a retirement account owner must withdrawal each year.


Guess which account type is exempt from RMDs? You guessed it - Roth IRAs. With a Roth IRA, you maintain full control over when and to what degree you make a withdrawal. Your investments can continue to grow tax-free, and you can avoid selling investments at a bad time simply to satisfy an RMD.


IMPORTANT NOTE: Roth 401(k) balances are still subject to RMD calculations. It’s very important that you rollover your Roth balance from the 401(k) into an IRA once you retire. If you are rolling your balance into a new Roth IRA, be mindful of the 5-Year Rule that will apply.


Save on Social Security & Medicare


You pay into Social Security and Medicare for decades, you retire, and then you get tax-free benefits, right? Wrong!


This is a VERY common misunderstanding. Up to 85% of your Social Security benefits are subject to taxes, depending on your taxable income. So, if you’re taking 100% of your withdrawals from a Traditional IRA, all of that is considered taxable income which increases the amount of your Social Security benefit that is subject to taxes. Roth IRA withdrawals, on the other hand, are not taxable income, reducing the amount of your Social Security benefits that are taxed.


Your Medicare Part B premiums require even more planning for two reasons. First, these premiums are also driven by your taxable income with several premium tiers. Recognizing even one more dollar in taxable income can put you in a different income bracket and increase your premiums by 40% or more. Second, these premiums are based on your taxable income reported two years prior. For example, Medicare is looking at your taxable income in 2020 to determine your Medicare Part B premiums in 2022. Again, Roth IRA withdrawals are not taxable income, which helps you manage your Medicare Part B premiums.


Better legacy terms


When loved ones inherit IRAs, they also inherit the tax consequences of the original owner. So, the beneficiary who inherits a 401(k) or Traditional/Rollover IRA is required to pay taxes on the withdrawals. If this asset is inherited by someone in the prime of their career, the RMDs could push them into a higher tax bracket, reducing the benefit of the inheritance, and possibly impacting other planning opportunities.


On the other hand, the tax-free aspects that benefit the owner of a Roth IRA will also benefit the heir. While RMDs apply to inherited Roth IRAs, someone in the prime of their career would receive 100% of the asset tax-free, assuming basic requirements are met, and without impact to their personal planning opportunities.


Conclusion


These benefits, both financial and psychological, are the reasons why we spend so much of our time helping people identify where they should be saving. To give our retirees more control and flexibility in the future, we assess if and to what degree Roth conversions make sense. For those in the early-to-mid stages of their professional careers, we find that they are making Pre-tax contributions when Roth would result in fewer taxes paid and all of the benefits mentioned above.


Remember - your tax strategy isn’t about paying fewer taxes now; it’s about paying fewer taxes period.


Frank Iozzo, CPWA®

President, Private Wealth Advisor