A Roth IRA Is the Perfect Tax Shelter

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No type of retirement account offers as many benefits to the typical middle-class investor as the Roth IRA can. By taking investing in a Roth IRA, you are probably going to build wealth faster, and keep far more of your income—due to the myriad tax advantages the accounts have built into the bankruptcy and tax laws of the United States.

A Roth Is a Tax Shelter

The Roth IRA may be the closest thing to the perfect tax shelter you will ever experience or need for retirement savings. For precisely this reason, Congress is strict about the amount of money you can contribute to it each year. With a Roth, you pay no taxes on your income from dividends, capital gains, interest, or rents.

Those advantages alone make it easy for a Roth IRA to be preferred over a regular brokerage account, as well as many 401(k) plans (note, however, most of these benefits can be found in a Roth 401(k) if offered by an employer and with higher contribution limits). One advantage of a qualified plan is often the matching funds that come from your employer with 401(k) or 403(b) plans.

You can tap into a Roth IRA without penalty to buy your first home or, in some cases, fund a medical emergency. If you absolutely must, you can even withdraw past contributions you've made to your Roth IRA without suffering the taxes and penalties that you would face with Traditional IRAs and 401(k) plans. This is accomplished via pulling out contributions that were already taxed and not the amounts from investment gains.

While a Roth IRA or Roth 401(k) are great tax shelters for retirement savings, other savings vehicles like health savings accounts (HSAs) are also suitable tax shelters for healthcare spending, and 529 accounts for college savings.

Roth IRA Tax Shelter Illustration

Assume you are 18 years old, and you plan on working until you reach age 65—at which point you'll retire. You meet the love of your life right out of high school and get married. The two of you decide that you don't need to be rich, but you do want to be secure.

You stick to one, single rule throughout your entire career: No matter what happens, in prosperity or poverty, you will fully fund your Roth IRA up to the contribution limits each and every year. No matter how desperately you need the money, you will never touch it; instead, you will protect it and allow it to grow tax-free.

The best method to increasing your IRA is to put money in it, and discipline yourself to never touch it.

In the first year, the most you can each put away into your Roth IRA is $6,000 per person. Between the two of you, that is $12,000, or $1,000 per month. You can buy used cars instead of new, clip coupons, and eventually earn more over time.

What could you expect? Based on the historical returns generated by stocks for the past century, assuming you reinvested your dividends, you could have several millions of dollars saved up by your target retirement age, even after taking into account the expected effects of inflation on purchasing power. After all, future purchasing power is what you're looking for in the first place.

At retirement you can convert the nest egg you've saved up in your Roth into annual passive income that is received income tax-free. You'd never need to touch the principal. You could live well for another two and a half decades at least and never touch a penny of principal. Instead, when you died, the money in your Roth IRA could be put into trust funds for your children and grandchildren, or given to charity.

How to Begin Investing for Retirement

Since a Roth IRA is a type of an account, rather than an investment itself, much like a savings account or brokerage account, it can be opened at nearly any mutual fund company, stockbroker, or a bank.

With a bank, however, your investment options might be limited to certificates of deposit (CDs), which probably isn't a good long-term strategy since you have very little chance of beating inflation with CD interest rates.

Make sure to watch out for fees when investing. You should not be giving up a considerable percentage of your assets or pay high commissions. The younger you are, the bigger bite those fees take out of your family's future wealth.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.