When starting to invest for retirement the first question many people ask is which type of IRA to open. The fact that there are two types of IRAs is pretty common knowledge. The words “Roth” and “Traditional” get thrown around all the time. Beyond that, many people don’t know what advantages the Roth IRA could harbor or what that could mean for your retirement lifestyle in the future. There are some specific advantages that a Roth brings that a traditional IRA does not. Let’s talk about how a Roth IRA could be an integral piece of your financial planning process.
The Roth Individual Retirement Account was created in the late 20th century in a bill called the Taxpayer Relief Act of 1997. Have you ever wondered where the Roth IRA got its name from? Even if you haven’t, I actually always have. Contrary to what some believe, “Roth” is not in fact an acronym. It does not stand for “Retirement Official Tax Harbor” or something like that. The Roth IRA is named after Sen. William Roth who introduced the idea of a retirement account with tax-free withdrawals to the senate in the late 1980’s. Because of his work in pushing the concept of such a retirement account, the new IRA was put into the tax-code under his name. Thus, the Roth IRA was born. The Roth IRA has a few advantages that make it a worthwhile consideration when financial planning. Let’s go over what makes them such a great option!
Tax Free Growth
While this is not a benefit exclusive to Roths, the Roth IRA does allow for tax free growth of your investment assets. This means that there are no tax bills due on short- and long-term capital gains as a result from sales in your IRA. This also means that any dividends and interest received in a Roth are not taxed within your IRA as long as they stay there. This treatment is the same as that of a traditional IRA, but differs from that of a non-qualified account where you would pay taxes on most dividends at LTCG rates and your marginal tax rate on interest payments received. This is of course on top of the taxes you pay on realized capital appreciation gains. The real differentiator for Roth IRAs is their ability for tax-free withdrawals at retirement.
Tax-Free Withdrawals and withdrawal of principle
While Traditional IRAs are funded with pre-tax money, Roth IRAs are funded with after-tax money. This means that while the money going into a Traditional will still need to be taxed when you withdrawal it at a later date, money contributed to a Roth will not be taxed. What a great way to create a bucket of tax-free income for retirement! ‘For retirement’ is the key wording here. Just like a traditional IRA, the gains within a Roth cannot be taken out until you reach the age of 59 ½ or your withdrawal will be subject to a 10% early withdrawal penalty AND additional taxation. These taxes and penalties are only on the early withdrawal of gains within a Roth. You can withdrawal the principle, the amount you have contributed, at any time tax and penalty free. This is another added benefit that makes Roth IRAs enticing. They create tax-free income in retirement and provide the ability to liquidate principle if you ever need to.
Because a Roth is an individual retirement account that means you, individually, control what you invest your contributions in. Within an IRA, which is simply the tax-deferred vehicle for your contributions, you can invest in so many things from stocks and bonds to mutual funds and real estate. You choose what you want to invest in and whether or not you want to want to withdrawal principal. This differs from an employer sponsored plan account like a 401(k) account. In a 401(k) there are usually a limited number of investments that you can choose from and you are not fully vested, you don’t fully own the money contributed, for sometimes up to 3 years. This is why we encourage people who are already fully taking advantage of their employer’s matching in their 401(k) to think about opening a Roth.
Roth IRAs are a pretty cool tool to use for retirement for a variety of reasons. They have really been on my mind lately because of the ever-changing landscape politically. Tax rates are forever changing and not ever in the way we would all want. The fact that Roths take away having to plan for that tax liability is an awesome thing. They are also cool because they can be opened at any age. As long as a person has taxable earned compensation they can contribute to a Roth. There is some extra paperwork when a person is a minor, but the ability to have that extra time in the market is very valuable.
If you or any of your relatives have questions about opening a Roth IRA and how to get started, please reach out to us. We would be happy to help! For more information about financial topics, check out our Facebook page at www.facebook.com/provisioretirement/.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.