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7 Reasons to Invest Money in a Roth Retirement Account Now

Money Girl podcast listener Peter D. asks, “Now that Congress has enacted lower tax rates for most Americans, does this make a Roth 401k more attractive than a traditional 401k?” Thanks for this great question, Peter.

Retirement accounts are the best places to save because they allow you to cut taxes on the investments you own inside them and build a bigger nest egg. Roth accounts deserve to be put on a pedestal because they come with more benefits than any other type of retirement account.

Problem is, Roth accounts are vastly underutilized and misunderstood. Many people tend to rely only on traditional accounts and may not realize the huge tax benefits, access to funds, and flexibility that come with a Roth IRA (Individual Retirement Arrangement) or an employer-sponsored Roth.

In this post, I’ll answer Peter’s question and explain the best reasons you should invest money in a Roth retirement account now.

Benefits of a Roth Retirement Account

Tax-free Income in Retirement
Penalty-free Early Withdrawals
No Income Limit for Workplace Plans
Unlimited Investment Choices
Easily Paired with Other Retirement Accounts
Non-working Spouses Qualify
No Age Limit to Make Contributions

Here’s more information about each of these fantastic Roth benefits.

1. Tax-free Income in Retirement

There are several differences between traditional and Roth retirement accounts, but the major one is how the funds are taxed. In both a Roth IRA and a Roth at work—such as a Roth 401(k) and a Roth 403(b)—you pay income tax upfront on contributions, but owe no additional tax when you take withdrawals in retirement.

As your investments earn income and receive dividends, they’re never taxed. If your account mushrooms in value over many years, you get to keep every penny.

With traditional retirement accounts, taxation is the opposite: You don’t pay tax on contributions, but you do pay income tax on withdrawals in retirement.

Getting tax-free income from a Roth in retirement is an amazing benefit.

Getting tax-free income from a Roth in retirement is an amazing benefit. Having less taxable income can reduce the likelihood that you’ll have to pay tax on your Social Security benefits and even cut your Medicare premiums.

So, your current and future tax situation plays a huge role in whether you should use a traditional or Roth retirement account. You can pay income tax on contributions now (with a Roth), or pay tax in the future on amounts withdrawn (with a traditional account).

No one knows for sure what the future holds, but if you believe that you’ll earn more money during retirement than you do now, and therefore would be subject to higher tax rates in the future, paying tax at a lower rate now makes sense. If you’re young or just starting your career, it’s possible that your income and tax rate is lower now than it will be when you retire.

This gets at the heart of Peter’s question about whether reforms in the Tax Cuts and Jobs Act of 2017 should make us re-think retirement account choices. The answer is yes, the new law can make a Roth slightly more beneficial for many Americans who now pay less income tax.

I say “slightly” because a Roth is already loaded with financial goodies, so paying a few percent less in income tax doesn’t radically change the game. But the reform does tip the scales a bit more in favor of choosing a Roth, when in doubt.

Also remember that new income tax brackets and reduced rates only last until 2025. No one knows if they’ll stick or be changed again. If the federal deficit keeps growing, tax rates may need to go up to bridge the budget gap.

Nonetheless, there’s no harm jumping on the Roth train now or diversifying your retirement contributions to both a Roth and a traditional account. You can always start or stop contributions at any time if your financial situation changes.

See also: 15 IRA Rules You Should Know

2. Penalty-free early withdrawals

While tax-free withdrawals in retirement are fantastic, there are even more Roth benefits to cheer about. One is the ability to tap your contributions without getting slapped on the wrist with a penalty.

In general, taking a withdrawal from a retirement account before reaching age 59½ comes with taxes, plus an additional 10% early withdrawal penalty. But because you pay tax upfront on Roth contributions, you’re allowed to take them out without paying income tax or a penalty.

However, your investment growth in the account (the money your contributions earned) has not been taxed. So, withdrawing any amount of earnings before age 59½ would generally be subject to income tax plus a 10% penalty.

For example, if you contribute $10,000 to a Roth and it grows to a value of $15,000, you can always withdraw your original contributions of $10,000 without paying tax or a penalty. This gives you access to your money for any reason, making it much more flexible than a traditional IRA or traditional 401(k).

I don’t recommend withdrawing funds from a retirement account, but having more flexibility with a Roth means you could get to your money in a pinch. 

Depending on how you want to use funds withdrawn from a Roth account, you may even be able to avoid the early withdrawal penalty on the earnings portion of your account. If you’re younger than 59½ and have owned a Roth for at least five years, you can spend Roth earnings penalty-free (but not tax free) to:

Pay higher education costs for you or a family member.
Buy, build, or rebuild a property that will be a first home for you or a family member, for up to $10,000. (Even if you’ve owned a home before, you’re considered a first-timer if neither you nor your spouse have owned a primary residence within the last two years.)
Pay medical bills that exceed 10% of your adjusted gross income.
Health insurance premiums while you’re unemployed.

Roth retirement plans at work may allow even more flexibility for penalty-free “hardship” distributions of earnings for certain expenses, including funeral costs.

I don’t recommend withdrawing funds from a retirement account, but having more flexibility with a Roth means you could get to your money in a pinch. 

3. No Income Limit for Workplace Plans

A workplace Roth and a Roth IRA are very similar; however, there are some important differences to know. First, anyone with income can use a Roth IRA. But you can only have a Roth 401(k) or a Roth 403(b) if it’s offered by your employer.

If you’re self-employed with no employees, you qualify for a solo 401(k), which may come with a Roth option, depending on where you open the account. Be aware that other retirement plans for the self-employed, such as a Simplified Employee Pension (SEP-IRA), only allow traditional, tax-deductible contributions.

A huge, often-overlooked benefit of having a Roth workplace plan or Roth solo 401(k) is that there are no annual income limits to qualify. With a Roth IRA, you can’t contribute if your income exceeds certain amounts for your tax filing status (such as single or married filing jointly). But anyone can contribute to a Roth 401(k) or 403(b), regardless of how much money you make!  

A huge, often-overlooked benefit of having a Roth workplace plan or Roth solo 401(k) is that there are no annual income limits to qualify.

Here are the Roth IRA eligibility rules for 2018:

If you file taxes as a single and your modified adjusted gross income is higher than $135,000, you cannot contribute to a Roth IRA. When you earn from $120,000 to $135,000, your contribution total is reduced.

If you’re married and file taxes jointly, you cannot contribute to a Roth IRA when your household’s joint modified adjusted gross income exceeds $199,000. And when you earn from $189,000 to $199,000, your contribution total is reduced.

If you have a traditional or Roth plan at work, you can also contribute to a Roth IRA in the same year, if you earn under these annual limits. If you earn more, you can’t make new contributions to a Roth IRA, but you can continue to enjoy the account’s tax-free growth.

4. Unlimited Investment Choices

You may be wondering how much you can contribute to a Roth and what types of investments you can make. The answer depends on whether you have a Roth IRA or a Roth at work.

For 2018, you can contribute up to $18,500, or $24,500 if you’re age 50 or older, to a workplace retirement plan. The limit is much lower for an IRA: $5,500, or $6,500 if you’re over 50.

Think of a retirement account like an umbrella that shelters what’s underneath from taxes. An IRA or a 401(k) are not investments by themselves, but are types of tax-advantaged accounts where you can own investments.

What you put under your retirement umbrella is up to you and there’s a wide range of choices. For instance, if you’re very conservative you could choose a savings account, CDs, treasuries, or bond funds.

For more growth, you could opt for index mutual funds or exchange-traded funds. And if you like a more aggressive approach, you could pick individual stocks or stock mutual funds.

Here’s an easy shortcut from my book, Money Girl’s Smart Moves to Grow Rich, to figure out how much stock you should own: Subtract your age from 100 and use that number as the percentage of stock funds to own in your retirement portfolio.

Different investing firms have different options. So, if there’s a certain investment you want to make, verify that it’s available before opening your IRA.

For workplace plans, choices are more limited. You’ll have a menu of diversified investment funds to choose from. If you don’t like your options, let your human resources or benefits administrator know, and they may be able to change them in the future.

But having more options isn’t necessarily better. Your main investing objective should be to purchase diversified funds that have enough underlying stocks for your risk appetite and time horizon.

For example, if you’re 40, you might consider holding 60% of your portfolio in stocks. If you tend to be more aggressive, subtract your age from 110 instead, which would indicate 70% for stocks. But this is just a rough guideline that you may decide to change.

5. Easily Paired with Other Retirement Accounts

Having a Roth IRA or a Roth at work is terrific—but don’t stop there. You can easily pair them with other Roth or traditional accounts, if you don’t exceed the total annual contribution limits.

For example, you can max out a Roth 401k at work and contribute to the maximum amount to a Roth IRA or a traditional IRA. You can also split your contributions between traditional and Roth accounts in any proportion you like.

For instance, you could contribute $10,000 to a traditional 401(k) and $8,500 to a Roth 401(k). Or $3,000 to a traditional IRA and $2,500 to a Roth IRA, if you’re under age 50 and don’t earn too much to get locked out of a Roth IRA.

Depending on your income, your tax deduction for a traditional IRA may be reduced or eliminated when you or a spouse also have a traditional workplace retirement plan (no matter your income, you can still contribute).

But there’s no conflict with a Roth IRA because those contributions are not tax-deductible. So, as long as you don’t earn too much to contribute to a Roth IRA in the first place, you can max out both a Roth IRA and a workplace retirement plan every year and get 100% of the tax benefit.

6. Non-working Spouses Qualify

One great feature of traditional and Roth IRAs is that if you’re married and don’t work, you qualify to have one. It doesn’t matter if you’re unemployed, a stay-at-home-spouse, or run your own part-time business.

One great feature of traditional and Roth IRAs is that if you’re married and don’t work, you qualify to have one.

This spousal IRA rule allows the breadwinner in a marriage to fund an IRA for a non-working spouse so he or she can also save for the future using a tax-advantaged account. This is an important benefit of being married, because when you’re single and don’t have income, you can’t contribute to an IRA.

So, if you file taxes jointly and have $11,000 in earned income, both spouses can max out an IRA. Or if one spouse is over 50, you can contribute a total of $12,000 ($5,500 to one IRA and $6,500 to the other). And if you’re both over 50, you can contribute a total of $13,000 ($6,500 to each IRA).

7. No Age Limit to Make Contributions

With most traditional retirement accounts you can only make contributions until age 70½. Then you must begin taking required minimum distributions (RMDs), unless you’re still working. With a Roth IRA, there’s no requirement to take distributions at any age. You can continue making contributions to a Roth IRA after age 70½ and your account can grow tax-free for your entire life.

The only limitation is that if you exceed the annual income threshold you become ineligible to make contributions.

Should You Invest in an IRA or a 401(k)?

If you have a retirement plan at work, that’s where I recommend you save for retirement first, especially if your employer offers a match. Those free matching funds are just too good to pass up, so always contribute at least enough to max out what your employer will contribute.

But if you don’t have a workplace retirement plan, or you’re a great saver and max it out, taking advantage of an IRA is a smart way to secure your financial future. You can make IRA contributions for the prior year by the tax filing due date in April. But you can only make 401(k) or 403(b) contributions until December 31st for that tax year.

For a summary of all the rules for using different retirement accounts, click here to download the free Retirement Account Comparison Chart PDF.

Where to Get a Roth IRA

If you’re ready to open a Roth IRA, it’s as easy as opening a bank account. You complete an application and transfer funds to activate the account.

Look for a company that offers the kinds of investments that you want to make, like mutual funds, exchange-traded funds, or stocks. If you have no idea what investments are right for you, choose a company that offers free investment advice and gives you simple options, like Betterment.

Go ahead and put your Roth IRA on auto-pilot by setting up recurring monthly deposits. In some cases, signing up for an automatic investing program eliminates a minimum balance requirement—plus, it will help you build wealth for retirement even faster.

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all about How To

Rabu, 07 Februari 2018

7 Simple Reasons to Invest in a Roth IRA or Roth 401(k)