A Roth IRA is a special type of retirement account that offers a unique tax advantage. While you don't get a tax deduction for your contributions to a Roth IRA as you do for a traditional one (with a Roth, your contributions were already taxed as income), like a traditional IRA, the account's investment earnings are tax-free. But best of all, when you take withdrawals from a Roth IRA, they're tax-free from federal and usually state income taxes.
This tax-free growth and withdrawals are especially valuable to younger retirement savers because the longer your money is invested in a Roth IRA, the larger the investment gains will be.
That's a key point, because to ensure your aftertax contributions earn enough to more than offset that tax hit, you need time, say 10 years, for your Roth IRA investments to earn solid returns. So Roths are most suitable for those under 50 years old, or anyone who's sure they won't have to make withdrawals for 10 years.
For example, let's say an individual contributed $5,500 a year for five years (the contribution limit for 2017 for investors under age 50) and then withdrew it.
Assuming the investments earned 7 percent, the account's value would be approximately $32,800 at the end of five years. The contributions would have been $27,500 and the earnings would be approximately $5,300 (which would be tax-free, assuming certain conditions are met).
Buts let's look at how this can work for a younger saver, with a longer time frame. Let's use the same amounts as above but assume this individual allowed the account to grow for another 20 years before making withdrawals. After 20 years, the account would be worth approximately $93,500. The contributions were still $27,500, but the earnings (which would be tax-free) are a much larger $66,000.
Clearly, the benefit of a Roth IRA is greater for savers who have a longer time horizon and can take advantage of compound growth of investment earnings.
But that's not all the benefits of a Roth IRA. Here are a few more reasons that considered together make a Roth IRA one of the best options for many retirement savers.
The rules for Roth IRAs allow you to withdraw all your contributions at any time, for any reason -- and the withdrawal is tax-free. The rule is that withdrawals are deemed to come from contributions first, and only after your contributions are fully withdrawn, are the earnings then distributed.
For earnings to be withdrawn tax-free, they're subject to certain restrictions. Generally, if you are 59½ or older and your Roth IRA has been open for at least five years, withdrawals of the earnings are tax-free.
Roth IRAs also provide a valuable option to manage your taxable income in retirement. Here's why.
When you retire, eventually you'll need to take withdrawals from all your accounts. If you're like most people, you'll have savings spread across a few different types of accounts, such as 401(k)s, IRAs and even taxable investment accounts. Having the option to take money from either taxable or tax-free accounts will give you the option to control your taxable income. And because withdrawals from Roth IRAs will be tax-free, you'll be better able to manage your overall taxable income in retirement.
In addition, Roth IRAs aren't subject to the required minimum distribution (RMD) rules that force retirement savers to take taxable withdrawals after age 70½. RMD amounts must be specifically calculated and withdrawn each year. If you don't take them correctly, hefty penalties can apply (in addition to the income taxes).
But because Roth IRAs don't have RMDs, you can leave the money to grow in a Roth IRA indefinitely and perhaps pass on more of your retirement savings to your heirs.
Roth IRAs offer a hedge against higher income tax rates. There's no way to know whether income tax rates will rise in the future. But if you're a young worker, your income will likely rise substantially over your lifetime. Since the tax code is progressive (meaning higher tax rates apply to higher levels of income), when you earn more in the future, you'll pay at higher tax rates.
So younger workers with lower income will pay less taxes on their initial contributions to a Roth IRA. But later, when they take withdrawals, these will be tax-free, while their other taxable income will likely be taxed at higher rates.
To contribute to a Roth IRA, you must have compensation from employment. If you earn too much, you may not be allowed to contribute (that is, for singles with adjusted gross income over $133,000 and married filers with incomes over $196,000). But if your employer offers a 401(k) plan with the ability to make Roth-type contributions, these limits don't apply.