While we would not always admit it, taxes are often a driving factor in our financial decisions.
Our drive to pay as little tax as possible often affects what car we buy, where we live, what house we purchase and many other everyday finances.
But taxes do not just have an impact on our daily lives, they also affect our retirement. Many investors recommend Roth IRAs to make the most of a retirement pot.
In this article, we take a look at what a Roth IRA is and its benefits as well as disadvantages.
What’s A Roth IRA?
Roth IRAs are individual retirement account which has certain tax advantages. Generally, a Roth IRA is very similar to a traditional IRA.
The key difference however is how both of them are taxed. Roth IRAs use after-tax dollars. This means that your contributions aren’t tax-deductible.
One of the reasons why investors recommend this type of account regularly for retirement savings is that the contributions and any associated earnings on contributions are tax free.
In addition, you can also withdraw any money tax-free after the age of 59.5 (although the account will have to have been open for a minimum of five years).
The Pros Of A Roth IRA
There are some powerful advantages when it comes to saving money in a Roth IRA for your retirement.
One of the biggest immediate advantages with a Roth ISA is that all the earnings in a Roth ISA can grow without any tax deductions.
No Taxes On Withdrawals
Another benefit of a Roth ISA is that once you get to your retirement age, you can withdraw the money without paying taxes.
This can make a big difference to your retirement pot, especially if you are paying a higher tax rate in retirement.
No Withdrawal Age
With a traditional IRA, you are forced to take your money out when you get to 72. However, this is not the case with a Roth IRA.
Easy Withdrawal Without Penalty
Many retirements accounts make it very difficult to withdraw contributions. With a Roth IRA, you can easily withdraw your money without any penalty fees.
Saying this, this doesn’t apply to the earnings. However, it is still a very good way of saving up an emergency fund.
With a traditional IRA or a 401(k), you will need to pay tax on your money when you begin to withdraw it in retirement.
In addition, you are also likely owing some tax on a part of your Social Security income as well.
Having a Roth means that you can move some of your distributions around without getting into the higher tax bracket of your income.
You can have some funds in a traditional IRA as well as in a Roth, all the while you also collect Social Security.
If you distribute your money across these different assets, you can avoid getting into a higher income tax bracket.
The Cons Of A Roth IRA
Despite all the great benefits with a Roth IRA account, there are also some disadvantages that you should be aware of when saving in this way.
Taxes Are Paid Upfront
You will still have to pay taxes on your money but with Roth IRAs, this just happens upfront.
Roth saving accounts are all about saving for the future, so if you struggle to save anything right now, then it’s better to make use of a traditional IRA where you get tax deductions now.
Low Maximum Contributions
The contribution limit for Roth IRAs changes frequently, and they are often similar to traditional IRAs.
The contribution limits are relatively low, compared to other retirement plans, such a 401(k) (Find out What Is A NonQualified Retirement Plan?).
One of the biggest negatives with this type of retirement savings account is that there are income limits.
This means that you will have to earn a certain income to be able to contribute to a Roth IRA.
Saying this, if you choose to convert your traditional IRA into a Roth, then there is no income limit.
This might not be an issue for many but you will have to set up a Roth IRA yourself.
In comparison, with a 401(k) you have the advantage that your employer encourages you to join and some even auto-enroll you. This is not just practical but it also means you can save without any additional effort.
With a Roth IRA, you will need to open the account yourself and you will need to manage your contributions yourself but this can often be done with an automatic standing order from your bank account.
What Is A Roth IRA Conversion?
A Roth IRA conversion happens when you move your funds from a normal IRA, a SIMPLE IRA or a simplified employee pension (SEP) IRA into a Roth IRA account.
There are no income limits when you convert your money from one of these savings account to a Roth.
Typically, you can only invest in a Roth IRA when your gross income is under a certain threshold.
However, there is no set limit for conversions, so saving with a traditional IRA and then moving your funds can provide a great option if you are a high earner.
Saying this, it is still an investment, and you should carefully consider the above mentioned pros and cons of a Roth IRA to be sure that it is the right way of saving for your financial situation.
A Roth IRA can be a very powerful way to save up a substantial amount for your retirement pot.
It comes with different tax benefits, such as tax-free withdrawal after a certain age.
Although these accounts do have an income limit, with a Roth conversion, you will be able to move your funds from certain other savings account into your Roth regardless of the income threshold.
This is what Roth IRAs particularly interesting for higher-earners who would not normally be eligible for this type of IRA.