If I could only contribute to one retirement account for the rest of my working career, it would be the Roth IRA/401k. Although there are many benefits to a Roth IRA, there are three benefits that I find to be most intriguing. On top of the benefits I lay out below, you will be pleased to hear that in recent years employers have made the Roth 401k more accessible and the contribution limit on Roth IRAs has been increased!
1. AFTER TAX INCOME
Taxes now or taxes later. That sentence encompasses the main difference between Roth and Traditional retirement accounts. With Traditional retirement accounts, the participant will receive a tax deduction upon making a contribution, and then will be taxed when they withdraw funds, typically during retirement. A Roth IRA contribution provides NO tax deduction. However when you withdraw funds from a Roth IRA, typically your contributions and investment earnings are tax free! Essentially, if an investor makes a $6,000 contribution to a Roth IRA and over 30 years it grows to $60,000, the investor has had a tax free gain of $54,000. Having worked with many retirees who worked and saved money, I can tell you that having a pile of tax free assets in retirement is a HUGE benefit! Unfortunately, many people who save money simply contribute to a traditional 401k or IRA and although saving is great in many respects, you are building a future tax obligation.
2. AVOIDING REQUIRED MINIMUM DISTRIBUTIONS
With congress passing the SECURE ACT in 2019 there are many changes impacting retirees, one of which is the required minimum distribution(RMD). For retirees starting in 2020, the new RMD age is 72. This means at age 72, you MUST begin taking distributions from your traditional retirement account. A huge benefit of Roth IRAs is that they avoid this mandatory withdrawal. Use your Roth IRA assets when you want - not when the government requires it. Of course, when you do use your Roth assets they are tax free! If you are subject to the RMD requirements make sure you know the rules very well, as the penalty for not taking a RMD is 50% of the required withdrawal.
3. ESTATE PLANNING ADVANTAGES
Life insurance and Roth IRAs are arguably the two most effective tools for transferring wealth from one generation to the next. Roth IRAs transfer tax free to your heirs, and as long as beneficiaries are properly stated, they can avoid probate court. Since Roth IRAs are tax free and are inherited with very limited hurdles, they can provide a source of liquidity to cover final expenses. Additionally once a Roth IRA is inherited by a non-spouse, that beneficiary can let it accumulate tax free for 10 years. This will allow for further tax free gains and ultimately make the inheritance left behind that much greater.
At this point, you might have some questions such as:
What is the maximum I can contribute to a Roth IRA?
- You can contribute $6,000 a year plus an additional $1,000 if you are over the age of 50.
What is the maximum I can contribute to a Roth 401(k)?
- The 2020 max Roth 401(k) contribution is $19,500 plus an additional $6,500 for those who are age 50 or over. This makes for a potential total contribution amount of $26,000.
There is an income threshold for contributing directly to a Roth IRA. The income threshold varies depending on your marriage status and phases in as your income goes up. However, in 2010, the income threshold was removed for converting a Traditional IRA to a Roth IRA. Which means even if you make too much to contribute to a Roth IRA, you could still contribute to a Traditional IRA then convert it to a Roth IRA. This strategy is known as the backdoor Roth IRA. Despite this strategy, Roth IRAs are still underutilized by investors and financial advisors despite the obvious benefits.
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Written by Brice Carter.