By Motley Fool, June 3, 2016
Saving for retirement isn’t easy, but I probably don’t need to tell you that. We’ve been hearing it on a pretty consistent basis from every survey and study published by finance-based firms.
For example, according to GOBankingRates, a third of Americans have absolutely nothing in retirement savings, and another 23% have between $1 and $1,000. On the flipside, its survey showed that fewer than 1 in 5 Americans has in excess of $200,000 set aside for retirement.
A separate study conducted by the Insured Retirement Institute showed that a whopping 45% of baby boomers hadn’t yet begun saving, which is very scary given that their leverage to grow their nest eggs is substantially reduced by waiting.
And if you still don’t believe this data, all you have to do is look at the published personal savings rates in the U.S. from the St. Louis Federal Reserve for confirmation. As of May 2016, personal savings rates were just 5.3%. Comparatively, consumers in most developed nations save in the high single digits to mid-double digits.
Roth IRA advantages you need to know
But, arguably the greatest retirement tool available is within reach of nearly all Americans: the Roth IRA. Roth IRAs have inherent advantages that very well could help get Americans of all ages on the right track for retirement, assuming you fall under the income requirements that allow you to contribute. You can find these requirement on the IRS website, but the rough gist is that only about the top 10% of income earners will be excluded from opening or contributing to a Roth IRA — although upper-income earners are probably more likely to have saved a decent amount toward their retirement, anyway.
For the remainder of Americans who qualify, here are the five huge Roth IRA advantages you need to know.
1. Tax-free income in retirement
The clearest advantage of choosing a Roth IRA over any other retirement tool is that any investment gains within a Roth are completely free of taxation for the life of the account. Contributions to a Roth are based on after-tax dollars, meaning you’ll receive no upfront tax deductions for your contributions. By comparison, employer-sponsored 401(k)s and traditional IRAs require you to pay federal taxes once you begin making withdrawals during retirement. In return, these tax-deferred accounts allow you to invest with before-tax dollars, thus reducing your current-year tax liability.
However, the back-end benefits could be enormous with a Roth. Because of time and compounding, you could wind up saving yourself from having to pay five or six digits’ worth of cumulative taxes during your retirement. Furthermore, with a Roth you’ll have less chance of being hit with a Medicare premium surcharge or having your Social Security benefits taxed, since Roth IRA distributions don’t count toward your income. With life expectancies lengthening, and medical costs outpacing inflation and wage growth, being able to keep more of your income in retirement is important.
2. No minimum required distribution
Nearly as important as never having to pay tax on your Roth IRA distributions is the fact that Roth IRAs have no minimum withdrawal requirements once you reach retirement age.
For example, 401(k)s and traditional IRAs mandate that retirees begin making minimum withdrawals after age 70 1/2 (and remember, you’ll pay federal income tax on these withdrawals). A Roth IRA doesn’t require that you begin taking a minimum amount out at any age. In fact, if you’d like, you can allow your account to continue growing in value, thus taking the maximum advantage of the effects of time and compounding. You’ll remain in complete control of the distribution schedule with a Roth.
3. No age restrictions when contributing
A Roth IRA also provides advantages over the traditional IRA when it comes to contribution flexibility. With a Roth, workers and retirees can keep making contributions as long as they’d like. This means millennials, Gen Xers, baby boomers, and even current retirees could all open a Roth and contribute to it right now if they’d like (assuming they fall under the aforementioned income limits). In 2016, contribution limits were $5,500 for those age 49 and under, and $6,500 for persons age 50 and up.
On the other hand, Americans are required to stop making contributions to a traditional IRA in the year they turn 70 1/2. There are no age limits for contributing to a 401(k), but it does require seniors to remain employed in order to keep contributing.
Because people are living longer than ever, being able to contribute into your 70s could still net you, or your heirs, considerable wealth.
4. Access to your contributions
Additionally, Roth IRAs offer a lot of flexibility. Most retirement tools are pretty cut-and-dried when it comes to making contributions and taking distributions. If you take money before you reach the qualifying age, you’ll pay a penalty. Even the Roth IRA has a penalty in place for taking unqualified distributions early.
However, Roth IRAs also have a handful of exemptions that do allow you access to your money completely tax- and penalty-free. For instance, since your contributions to a Roth are in after-tax dollars, you can withdraw the amount you’ve contributed at any time completely penalty-free. This obviously isn’t a great idea given that you could be hampering your ability to grow your nest egg over time, but if you find yourself in a cash crunch, you always have access to the amount you’ve contributed to a Roth.
Other circumstances could also allow for penalty-free withdrawals before reaching age 59 1/2 (the qualifying age for Roth IRA withdrawals). For instance, paying back taxes, being disabled, or covering unreimbursed medical expenses that exceed 10% of your adjusted gross income (or 7.5% for people turning 65 or older in the 2016 tax year) allow for a penalty-free withdrawal.
5. Long-term mindset
Finally — and this isn’t necessarily a unique component of the Roth, but is a big reason why it’s such a great retirement tool — the Roth IRA has a five-year rule in place that encourages a long-term mindset among investors. The five-year rule mandates that five tax years must pass following a contribution before a qualified distribution can be made. This rule discourages account holders from diving in and out of their investments, which over time has proven not to be as successful as buying and holding quality investments over the long term.
If you need to get your retirement on track, arguably the smartest thing you can do is open a Roth IRA.
To Your Successful Retirement!
Michael Ginsberg, JD, CFP®