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Why You Should Have a Roth IRA

Many folks choose to supplement their employer-sponsored 401(k) retirement savings plan with an individual retirement account or IRA. This article covers some of the reasons why you might consider saving for retirement with an IRA, and specifically why you might want to open a Roth IRA. (For more, see: Why Rollover Your Retirement Assets into an IRA?)

To begin, there are two types of IRAs that one can choose to save for retirement:traditional IRAs and Roth IRAs. Both types have the same contribution limits in 2016: $5,500 ($6,500 if you're age 50 or older). But that's where the similarities end. Let's take a look at a few of the main characteristics for each and see how they differ. (For more, see: An Introduction to Roth IRAs.)

Traditional IRAs

  • Contributions are made pre-tax (so you save on the front end)
  • Retirement distributions are taxed at ordinary income rates (you pay on the back end)
  • You must take annual required minimum distributions (RMDs) once you've reached age 70 1/2
  • You are not allowed to make any contributions after age 70 1/2
  • Early distributions are subject to taxes and penalties
  • With a few exceptions, you can begin to take distributions at age 59 1/2 without penalty

Roth IRAs

  • Contributions are made after tax (so you pay on the front end)
  • Retirement distributions are not taxed (so you save on the back end)
  • No annual RMDs required at age 70 1/2
  • You can continue to make contributions after you've reached age 70 1/2
  • Early distribution of contributions is not subject to taxes or penalties
  • With a few exceptions, you can begin to take distributions at age 59 1/2 without penalty

There are contribution limits for Roth IRAs based on your income level. If you make too much money you may be phased out partially or completely. Refer to the IRS website for a table of amounts based on your modified adjusted gross Income (MAGI). Full contributions can be made for married joint filers with MAGI below $184,000, or single filers with MAGI of less than $117,000. Contributions are phased out completely when your income exceeds $194,000 (married) or $132,000 (single). (For more, see: Roth IRA Contribution Limits in 2016.)

So as you can see from the points above, one of the primary advantages of choosing the Roth over the traditional is that you can take money out in retirement and pay no taxes on those distributions because you paid the taxes when you contributed money. What this means to you is that if tax rates are higher in retirement then you're better off paying a lower tax on contributions now. That way, your contributions grow tax free and your qualified distributions in retirement (after age 59 1/2) are not taxed either. It's a double tax savings.

But How Can you Predict Your Tax Rate in Retirement?

It's impossible to know for sure what your tax rate will be in 20, 30 or 40 years. It depends on so many different factors, including whether Congress decides to raise or lower tax rates in the future. And experts seem to agree that taxes will be higher. Do you expect your income (and Social Security benefits) to be greater than they are today? Keep in mind that you're going to lose a bunch of valuable tax deductions and credits when your kids are fully grown and out of the house. 

Roth IRAs are Also Great for Estate Planning Purposes

Since Uncle Sam doesn't require you to take distributions down the road, you can keep your assets in a Roth IRA for the rest of your life. This also makes a Roth IRA a great wealth transfer vehicle because beneficiaries won't pay income taxes on distributions and Roth IRAs do not go through probate (but they may still have to pay estate taxes). (For more, see: The Basics of Roth IRA Contribution Rules.)

Can I Use Funds from My IRA to Pay for My Child's College?

The short answer is yes, you can use funds from your traditional or Roth IRA to pay for college. With the traditional IRA, you will not be subject to the 10% penalty but you will owe income taxes on the amount distributed for qualified education expenses for the taxpayer, the taxpayer's spouse, or the taxpayers' s child or grandchild. Qualified education expenses include tuition, fees, room and board.

With the Roth IRA, the taxpayer is always able to withdraw amounts up to his/her total contribution without income tax or penalty. However, excess distributions can avoid the 10% penalty if proceeds are used to pay qualified education expenses. So clearly, the Roth IRA is an attractive vehicle for college savings as well as retirement savings and estate planning. (For more, see: How a Roth IRA Works After Retirement.)

Charlie Shipman is the Managing Principal of Blue Keel Financial Planning, LLC, an independent, fee-only Registered Investment Advisor based in Weston, Connecticut. Blue Keel provides prudent planning and sound investment management services primarily tailored to the needs of executives, small business owners, entrepreneurs, and their families.