Pros and Cons of Roth IRAs

Is a Roth IRA right for you?

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Roth IRAs are personal retirement savings accounts that offer tax benefits. Roth IRAs provide the benefit of allowing tax-free withdrawals in retirement, including on earnings, instead of getting immediate tax benefits for contributions as you do with traditional IRAs. 

Roth IRAs do offer tax-free income, but they aren’t always the best choice for retirement plans for everyone. Learn when Roth plans make sense for investing toward retirement, and when they don’t.

Key Takeaways

  • IRAs provide an investment strategy for tax-free retirement income.
  • Roth IRAs can be used in tandem with other retirement plans.
  • Roth IRAs are more flexible than other types of retirement plans as far as withdrawing your principal.

Pros and Cons of Roth IRAs

Roth IRAs are a popular way to save for retirement because of their tax advantages and flexibility with withdrawals. However, there are some downsides to consider as well.

Pros
  • Savings grow tax-free

  • Withdraw contributions anytime

  • Qualified distributions are tax-free

  • Flexible investments

  • No required minimum distributions

  • Tax diversification at retirement

Cons
  • Contributions are taxable

  • Low contribution limits

  • Not available for higher income earners

  • Rollovers from traditional plans are taxable

Advantages of Roth IRAs

Tax-free income is an attractive strategy for retirement. And a Roth IRA is one of the few ways to invest toward tax-free income for retirement.

Savings Grow Tax-Free

All earnings in a Roth IRA grow tax-free. Traditional IRA earnings grow tax-deferred because they are taxed as income when distributed in your retirement.

Qualified Distributions Are Tax-Free

As long as the Roth account has been open at least 5 years and you are 59½ or older, any distributions from a Roth account are considered qualified. Distributions that are not qualified may be taxable, and subject to a 10% penalty.

Withdraw Contributions Tax-Free Anytime

Roth IRAs are “first in, first out,” which means that contributions are withdrawn before any earnings. For example, if you contributed $6,000 to a Roth IRA for 6 years, you could then withdraw up to $36,000 without tax or penalties. 

During your working years, you can tap a portion of your Roth IRA, say if you need the money to buy your first home or start a business.  

Flexible Investments

You can use Roth IRAs to invest in a variety of asset types, like stocks, bonds, and even cryptocurrency. Some assets like life insurance and collectibles are not permitted.

Your Roth IRA allocations can easily be changed with your investment strategy to reflect your goals and time horizon. 

No Required Minimum Distributions

Employer-sponsored retirement plans like 410(k)s and traditional IRAs require minimum distributions (RMD) in which you must start taking withdrawals at a certain age. The amount of the RMD, and taxable income increases each year.

In contrast, with a Roth IRA, you are not required to take distributions and you can keep as much money as you like in your Roth IRA as long as you are alive.

Tax Diversification

Even if you are contributing to an employer-sponsored plan, you may also be eligible to contribute to a Roth IRA. 

A well-diversified portfolio of taxable and non-taxable investments can help you maximize retirement income.

Disadvantages of Roth IRAs

While tax-free income is attractive to many investors, a Roth IRA may not always be the ideal choice for a retirement savings account, especially if your employer offers a plan with matching contributions.

Here are the potential downsides to a Roth IRA to consider:

Contributions Are Taxable

Roth IRA contributions are made after taxation, which affects your cash flow for that year. For example, if you are in a 24% marginal tax bracket, you have to earn $7,897 to have $6,000 to invest. Traditional plans on the other hand are tax deductible. You only have to earn $6,000 to invest $6,000.

Low Contribution Limits

IRAs have lower contribution limits than employer-sponsored plans like 401(k)s. The maximum contribution to a Roth IRA is $6,000 for 2022, while employer-sponsored plans have a limit of $20,500. It may not pay to start a Roth IRA if you haven’t ‘maxed out’ your plan at work so that you are taking advantage of all matching contributions.

Not Available for High-Income Earners

Roth IRA contribution limits are reduced based on your adjusted gross income. The limits for 2022 are:

  • Single taxpayers and heads of household: $129,000 to $144,000
  • Married, filing jointly: $204,000 to $214,000
  • Married, filing separately (and you lived with your spouse): $0 to $10,000

You can’t contribute to a Roth IRA if you are married filing jointly and your adjusted gross income is more than $214,000 or if you are single and your income is more than $144,000. 

Rollovers From Traditional Plans Are Taxable

If you want to transfer or ‘rollover’ money from a traditional IRA to a Roth IRA the entire amount is taxable. That can potentially mean a significant reduction in your retirement savings. The rollover could also put you in a higher tax bracket for the year, increasing your tax bill.

Should You Use a Roth IRA?

One of the advantages of Roth IRAs is that you can use them with other types of plans. Here are some things to consider as you develop your retirement savings strategy.

Tax Rates Today vs. Tax Rates at Retirement

Roth IRAs work can be ideal when your income tax rates will be higher when you retire than they were when you contributed. 

While you don’t pay tax on the distributions, you do pay tax on your contributions. If you think you’ll be in a lower tax bracket at retirement than you are now, a traditional plan may be a better choice.

How Much Can You Contribute?

If you aren’t contributing the maximum to an employer-sponsored plan that offers matching funds, the Roth IRA may not be the best choice. 

If you don’t have a plan at work, and your budget doesn’t allow for maximum Roth contributions, a traditional plan may be a better choice. The additional money invested in a pre-tax plan could compound into a significant difference over time.

Alternatives to Roth IRAs

Standard Brokerage Accounts

A standard brokerage account offers a broad range of investment choices, including individual stocks and bonds, mutual funds, and ETFs. Capital gains and qualified dividends receive capital gains treatment at lower tax rates. 

Employer-Sponsored Plans

Many employers offer employees 401(k) plans or other retirement plans as benefits. Some employers make matching contributions to the plans for employees. Employer-sponsored plans may also offer Roth options.

Traditional IRAs

Traditional IRAs offer tax-deductible contributions. You can have as many IRAs as you like, as long as the total contributions don’t exceed the IRS limit. 

Annuities

Annuities are long-term investments that are issued by insurance companies to protect you from outliving your funds by providing a fixed-income stream. They offer tax-deferred growth and guaranteed income. The way annuity withdrawals are taxed depends on whether contributions were made with pre-tax or after-tax money.

Frequently Asked Questions (FAQs)

How do you open a Roth IRA?

Opening a Roth IRA is simple. First, choose a custodian, which is usually a bank, brokerage firm, or other financial institution. Then you’ll complete a form with basic personal information to open the account. Finally, you’ll contribute money to the account and invest it according to your goals. 

How should you invest the funds in a Roth IRA?

A Roth IRA is part of a retirement plan. Your investments should fit into your overall retirement plan strategy, including your risk tolerance, goals, and time horizon. You can invest your funds in a variety of assets, from stocks to bonds and more. If you don’t have a plan in place, consider getting professional advice.

What is a backdoor Roth IRA?

Backdoor Roth IRAs are a way for high-income taxpayers to get money into a Roth IRA. With this backdoor strategy, you contribute to a traditional IRA, which has no income limits, and then convert the funds into a Roth IRA. There are no income limits on these transfers. 

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