Source: 401kcalculator.org via Flickr.
When it comes to saving for your retirement, an individual retirement arrangement can be an excellent way to set aside money while taking advantage of tax breaks. Unlike a traditional IRA, a Roth IRA doesn't allow for an immediate tax deduction on contributions, which is a turn-off for many investors, especially younger ones. However, a Roth IRA comes with plenty of perks that you need to know about before making a decision.
Continue Reading Below
1. You can take back your contributions whenever you wantWhen you contribute to a traditional IRA, you are generally not allowed to tap that account at all until you reach age 59-1/2, lest you incur large penalties. If you should decide for whatever reason that you need to withdraw some funds early, then you'll most likely have to pay a 10% penalty and income tax (because you contribute on a pretax basis) on the amount of the withdrawal.
With a Roth IRA, you've already paid income taxes on your contributions. For this reason, you're allowed to withdraw your contributions (but not any investment gains) whenever you want, for any reason, without paying a penalty. This makes a Roth IRA an excellent option for investors who don't like the idea of having their money tied up until they reach retirement age.
2. But you don't have to withdraw your money at all Another unique feature of Roth IRAs is that you don't have to take your money out no matter how old you get.
With traditional IRAs and 401(k) accounts, you are required to take minimum distributions once you reach age 70-1/2. In other words, you have to start taking your money out, even if you don't need it. This shrinks your savings and thereby reduces their compound growth.
In a Roth IRA, you can leave your money in as long as you want, even if you live to be 100 or more. This lets you take full advantage of tax-free compounding for as long as you want. And if you plan to leave some of your IRA savings to loved ones, a Roth IRA will let your savings grow untouched until the day you die. So if there's a good chance you won't need to tap into your IRA early in retirement, a Roth account could be the best option for you as well as for your heirs.
3. Older investors can contribute extraThis is a feature that isn't unique to Roth IRAs, but many investors don't know about it. Basically, the IRS allows for older investors to catch up on their retirement savings by contributing more each year.
The annual contribution limit for both the traditional IRA and the Roth IRA is $5,500 for 2015. However, if you are aged 50 or older, you can contribute an additional $1,000 for a total of $6,500. And don't underestimate the effect this could have. If you start investing the full amount allowed when you turn 50, and then retire at 65, that extra $1,000 per year could mean an extra $28,000 in retirement savings, given 7% average annual investment returns.
4. Even if you exceed the income limits, you can still open an accountThe IRS sets an upper income limit for people who wish to open and contribute to a Roth IRA. Single taxpayers can contribute a reduced amount if their modified adjusted gross income is between $116,000 and $131,000, and if their earnings are above the upper threshold, they cannot contribute directly to a Roth IRA. For married couples filing jointly, Roth IRA contributions begin to phase out at modified AGI of $183,000 and are disallowed at income above $193,000.
However, many people don't realize that there is a "back door" to a Roth IRA. If your income is too high for you to contribute directly, you can contribute to a traditional IRA and then convert that account to a Roth IRA. In 2010, Congress took away the income limits for IRA conversions, so this option is open to anyone. Keep in mind, though that as of 2015 you can only perform one IRA conversion per year.
As with a standard Roth IRA, you'll have to pay income tax on any pretax funds you convert, but if don't qualify to open a Roth directly, this is the best way to do it.
5. It takes tax uncertainty out of the equationAs I mentioned in the introduction, Roth IRA contributions are taxed up front, whereas traditional IRA contributions are tax-deductible.
However, consider the benefits of this. Not only do you get the delayed gratification of tax-free withdrawals in retirement, but you can't know what your income tax rate will be then? For all you know, marginal tax rates for middle-income individuals could rise to 50% or more by the time you retire. It seems unlikely, but it's possible.
So, by contributing to a Roth IRA, you at least know what tax rate you'll be paying on your income. Whatever happens to the tax brackets between now and your retirement will have no effect on your retirement income. And if you wholly expect to be in a higher tax bracket when you retire, then the Roth offers obvious tax savings.
In my opinion, the peace of mind this provides is worth giving up the up-front tax benefits.
Is it right for you?Ultimately you need to decide whether a Roth IRA is the best option for you. If the current tax break is important to you and you're fairly certain you won't need to prematurely withdraw your contributions, go ahead and use a traditional IRA. However, for millions of Americans, a Roth IRA simply makes more sense.
The article 5 Facts About Roth IRAs You May Not Know originally appeared on Fool.com.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
Continue Reading Below