Why a Roth IRA Might be a Better Way to Save for Retirement
An Individual Retirement Account (IRA) is a great way to save for retirement because, as you invest the money and it grows over time, you don't have to pay tax on that investment income-ever. Some people might not realize that there are two types of IRA: a traditional IRA and a Roth IRA. If you're young, you're good at saving money, you want to build an emergency fund, or you expect to have a side hustle when you retire, a Roth IRA might be a better choice than a traditional IRA.
The way it's designed, a traditional IRA makes assumptions about work and retirement that are, well, traditional. It expects you to work and earn the most money when you're young and then to quit work, retire, and live off the money you saved when you're older. The assumption is that you will be in a higher tax bracket when working than when you're retired. A traditional IRA lets you defer paying tax on the money you put into your account, called a contribution, until you take it out during retirement, presumably at a lower tax rate. However, you must withdraw the money and pay tax on it, even if you don't need it. You never have to pay tax on your investment income in the account.
These traditional assumptions no longer reflect reality for an increasing number of people. Things are different today. Side hustles or gigs are common, and you might never stop working altogether, either by choice or necessity. If you start saving money early, your tax bracket might be lower when you're young than when you retire. You might even save more money than you need for retirement. If there's a global disaster, you also might need to tap into an emergency fund.
A Roth IRA doesn't make the same assumptions about your income now and in retirement. There's no special treatment for a Roth IRA contribution, so you've already paid tax on the money you put into your account. Since the benefit of an IRA is that you don't have to pay tax on the appreciation, all your withdrawals from your Roth IRA account are tax-free. A Roth IRA can also provide a safety net as a backup emergency fund. Again, since you've already paid tax on your contributions, you can withdraw them at any time without paying any tax or penalty. However, you must meet certain age and other criteria to withdraw your investment income early without paying penalties or taxes. Best of all, if you don't need the money when you retire, you don't have to withdraw it. Some people can even keep contributing to a Roth IRA during retirement. A Roth IRA can turn out to be a great way to pass tax-free funds within your estate.
Every savings account that provides tax-free income has rules and restrictions, and a Roth IRA is no different. Consider these details about how the accounts work before you make any deposits.
You must open a Roth IRA account at a financial institution that the IRS approves. While most people open a Roth IRA at a brokerage, other eligible institutions include banks, credit unions, and savings and loan institutions.
There are limits to how much you can earn and still contribute to a Roth IRA. For example, in 2021, If you're single and make over $140,000 or you're married, and your combined income is more than $208,000, you probably can't contribute to a Roth IRA. These limits are not exact, however, but based on a formula. If you're close to the limit, use the formula to calculate the exact limitation that applies to you, given your filing status and income.
Each tax year has a defined maximum contribution you can make. For example, in 2021, the maximum contribution was $6,000 if you're under age 50 and $7,000 if you're at least age 50. However, regardless of the maximum contribution amount, you can never contribute more than the amount of earned income you have in a tax year. Earned income is income from a salary as an employee or paid to you as a contractor or nonemployee. It's usually the earnings on a W-2 or a 1099-NEC. If you retire and still have earned income from a part-time job or side gig, you can continue to contribute to your Roth IRA, as long as you don't contribute more than your total earned income or the maximum for that tax year. If you don't have any earned income, but your spouse does, your spouse can contribute to your Roth IRA on your behalf, provided that the total of your combined contributions doesn't exceed your spouse's earned income for the year.
You can't roll over another investment account or transfer stock to your Roth IRA because you're required to make all contributions in cash. You can contribute in the calendar year following the tax year it belongs to as long as you do it before the income tax deadline for the designated tax year. For example, you can contribute on April 1, 2021, for the 2020 tax year because it's prior to the April 15, 2021 deadline for 2020 tax returns.
Depending on where you open your Roth IRA account, you should have a wide variety of investment options, including mutual funds, money market funds, stocks, bonds, and Exchange Traded Funds (ETFs). While you can seek advice from an investment advisor, you make the final decision about how you invest the money in your Roth IRA.
The Federal Deposit Insurance Corporation (FDIC) will only insure you for up to $250,000 of your total savings deposits at a bank. This means that if the sum of the money you have at a bank in a savings account, traditional IRA, Roth IRA, and Certificate of Deposit (CD) exceeds $250,000, you are technically at risk for the amount over $250,000 if the bank fails.
Having money in an account that you can technically withdraw at any time without paying taxes or penalties provides some peace of mind. While you shouldn't plan on withdrawing money you contribute until you retire, a Roth IRA can serve as an emergency backup fund if something catastrophic happens, like losing your job due to a global pandemic. If you try to withdraw income you've made on your investments before you turn age 60 or less than five years after you open the account, you might have to pay both taxes and a 10 percent penalty on the money you withdraw, depending on what you need it for.
If you start saving early, you're good at saving money, your investments pay off, and your side hustle is on autopilot, you might discover that you have enough money when you retire, and you don't need to withdraw any money from your Roth IRA. A big advantage compared to a traditional IRA is that you don't have to make any withdrawals if you don't need to. You can use the account as a way to pass tax-free money to your heirs.
Whether you put money into an IRA, a Roth IRA, a 401(k) plan, a savings account, a money market account, or a CD, the most important thing is that you save some money. Everyone should get into the habit of saving even a small amount of money every month. While traditional IRAs have been a great way to save for retirement, a Roth IRA might be a better choice because it better reflects current attitudes toward work, savings, and retirement.