Financial advisors have the benefit of seeing retirement from several different perspectives. As a result of their experience, they can usually discern what planning strategies and tools have the most benefit for retirees. The Roth IRA is perhaps one of the most underutilized, yet beneficial, of all retirement planning strategies. Although there are many benefits to a Roth IRA, there are three that I find to be most intriguing.
1. After Tax Income
The main benefit of a Roth IRA is also the main difference between a Roth IRA and traditional retirement accounts (IRAs, 401(k)s, 403(b)s). With traditional retirement accounts, the investor will typically receive a tax deduction when they make a contribution and then are taxed when they withdraw funds, typically during retirement. The deduction on traditional retirement accounts is of course subject to IRS rules. With Roth IRAs, the participant receives no tax deduction at the time of deposit but avoids taxes when they withdraw the funds out of their account. This provides a source of tax free income for retirement. (For more, see: An Introduction to Roth IRAs.)
Essentially, if an investor makes a $5,000 contribution to a Roth IRA and over 30 years and it grows to $50,000, the investor has had a tax free gain of $45,000. The downside is that the investor does not receive a deduction when they make an initial contribution. Although not receiving a deduction may be a hard pill to swallow during working years, there are several reasons one would want a tax free pool of money during retirement. A few reasons include rising tax rates, avoiding taxes on Social Security, large purchases or to keep one’s tax bracket below a certain level. By starting a Roth IRA in addition to traditional retirement accounts, investors are tax diversifying their retirement savings.
2. Avoiding Required Minimum Distributions
Investors may or may not realize that once they reach age 70 1/2, they must begin withdrawing money from most traditional retirement accounts at a rate which is determined by the IRS. This is an IRS rule known as required minimum distributions (RMDs). The intention of this rule is to get investors to withdraw funds from retirement accounts and pay taxes. Once taxes have been paid on these retirement funds, the IRS does not really care what taxpayers do with the money. They simply wish to tax these funds.
The penalty for not taking a RMD is 50% of the required withdrawal. For example, if an individual is required to take a $5,000 RMD and does not take it, the penalty is $2,500. There is some comfort in the fact that Roth IRAs do not require RMDs. Roth IRA owners can keep funds in their Roth IRA until the day they die if they wish. This brings me to my next major benefit, the estate planning advantages of Roth IRAs.
3. Estate Planning Advantages
For transferring wealth from generation to generation, Roth IRAs are second only to life insurance in efficiency. The money in Roth IRAs passes directly to heirs tax free. This can provide liquidity at death if there are final expenses or estate taxes. Roth IRAs provide a significant advantage to heirs over traditional retirement accounts because traditional retirement accounts are 100% taxable to beneficiaries and require them to begin taxable RMDs based on their life expectancy. This can be of particular concern if heirs are still working and in a high tax bracket. Under certain circumstances, spouses are exempt from this rule.
Roth IRAs have grown in popularity since 2010 when the income restriction on converting a traditional IRA to a Roth IRA was lifted. However, Roth IRAs are still underutilized by investors and financial advisors despite the obvious benefits. Although anyone with a traditional IRA can convert to a Roth IRA, that strategy may not be right for everyone. Investors should consult their financial advisor and tax professional before making decisions that may result in tax consequences. (For more, see: Roth vs. Traditional IRA: Which Is Right for You?)