If you are saving for retirement and are wondering what type of IRA to choose, you may want to consider a Roth IRA. This investment type offers several advantages over traditional IRAs.
First, Roth distributions are tax-free. Second, they do not require age-based withdrawals. Third, they can continue to grow tax-free for decades.
Tax-Free Withdrawals
If you’re looking to save tax-free in retirement, a Roth IRA may be the right choice for you. Unlike traditional IRAs and 401(k)s, Roth IRA contributions aren’t tax-deductible, but the investment earnings grow tax-free.
Withdrawals are tax-free if they’re made after you reach age 59 1/2 or if you meet certain exceptions. These include purchasing your first home, paying for college, withdrawing money to cover medical expenses, and having a child or adopting a baby.
Nevertheless, it’s important to remember that these withdrawals may be subject to income taxes and a 10% early-withdrawal penalty if they don’t qualify as qualified distributions.
For example, let’s say you first opened a Roth IRA in 2023 and earned $1,500 in your account that year. The IRS rules state that you must wait five years to satisfy the holding requirement before a withdrawal can be made without tax, but you wouldn’t owe any income taxes until 2024 because the earnings are considered in your conversion basket and not your original contribution basket.
No Required Age to Take Distributions
Unlike traditional IRAs, Roth IRAs do not have age requirements for distributions. This allows people to save on taxes when they expect to make a larger income in retirement.
Roth IRAs also allow an heir to inherit tax-free withdrawals, which can be useful for a spousal or nonspousal beneficiary. However, the SECURE Act of 2019 eliminated the stretch IRA strategy that allowed nonspousal beneficiaries to take RMDs on their life expectancy instead of the original owner’s.
The IRS frowns on taking IRA earnings early. That can trigger a 10% penalty and a hefty amount of income taxes.
There are some exceptions to this rule, including if you are younger than 59 1/2 and you meet the 5-year holding period. But if you’re younger than that, you must still pay income taxes on the earnings portion of your withdrawal.
No Maximum Contribution Limits
If you contribute to your Roth IRA each year, your earnings can grow tax-free. However, you should also keep an eye on your contribution limit.
The maximum contribution amount for 2022 is $6,000 if you’re under 50 and $7,500 if you’re older. For 2023, that number increases to $6,500 if you’re under 50 and $7,500 for those who are older.
You may be able to contribute more than the maximum if you have employer-sponsored SEP or SIMPLE IRAs. The extra amount will be taxed as ordinary income, but you won’t have to pay a penalty on it.
The limits on your Roth IRA contributions are reduced as your modified adjusted gross income (MAGI) rises. Check out the MAGI phase-out ranges for a full picture of your potential limit on contributions.
Investment Options
There are a number of investment options available through a Roth IRA. These include stocks, bonds and managed funds.
Stocks are an excellent option for a Roth IRA because they provide growth potential and capital gains can be sheltered inside the account until withdrawn tax-free in retirement. Alternatively, income-oriented stocks that pay high dividends can also be a good choice.
Bonds are another useful asset class for a Roth IRA, because they can offer interest income that is tax-free. However, bond funds are not as risky as equity funds and don`t provide the same growth potential, so they typically have lower returns.
Managed funds are another great option for a Roth IRA, especially ETFs that track specific market indexes. Ideally, investors should include a few core index funds in their portfolios to achieve diversification. These investments can be inexpensive and offer significant returns over the long term. Robo-advisors can also be a cost-effective option for building and managing an IRA portfolio.