Investment Ideas, Retirement Planning

The Underutilized Roth IRA


While most investors are familiar with the traditional IRA, only some understand the powerful benefits of a Roth IRA.

A Roth IRA is a particularly useful investment for millennials, who understand the benefits of compounding tax-free over long periods of time.

According to Fidelity, more than half of IRA contributions go into Roth IRAs, which is especially common among people aged 23-38.  Fidelity found that 74% of the contribution dollars of millennials are invested in Roth IRAs.

Have you ever considered adding a Roth IRA to your investments?

What is a Roth IRA? 

Unlike traditional IRAs, contributions to a Roth IRA are not tax deductible.  Withdrawals are tax-free and penalty-free after five years and after you reach 59½ years old. 

You can contribute to a Roth IRA at any age, as long as you have qualifying earned income.  

Do you qualify for a Roth IRA?

If you qualify, the total contributions you can make each year to your traditional and Roth IRA for 2023 is $6500 ($7500 if you are age 50 or older).

You can contribute the maximum amount to your Roth if you are married, filing jointly, and your modified adjusted gross income is less than $218,000.

If you are single, head of household, or married, filing separately, and you did not live with your spouse at any time during the year, you can contribute the maximum amount to a Roth if your adjusted gross income is less than $138,000.

There are also provisions for reduced contributions at certain income levels.

Deferred Gratification: Why Roth IRA is better

In a famous experiment conducted at Stanford University, researchers tested hundreds of children aged 4 and 5.  They brought each child into a room a placed a marshmallow in front of them.

The child was told the researcher would leave the room, and if the child didn’t eat the marshmallow when she returned, they would be rewarded with a second marshmallow.  

Relatively few of the children were able to wait 15 minutes while the researcher was out of the room before consuming the marshmallow.

In an extensive follow-up study (over a 40-year period), the researchers found the children who delayed gratification “ended up having higher SAT scores, lower levels of substance abuse, lower likelihood of obesity, better responses to stress, better social skills as reported by their parents, and generally better scores in a range of other life measures.”

Other studies have shown that delaying gratification is “one of the most effective personal traits of successful people.”

When you choose a Roth IRA, you are choosing delayed gratification.  You are giving up the immediate benefit of deducting your contribution from your taxes which you get with a traditional IRA.  You are deciding to defer that benefit for tax-free withdrawals at age 59½.  

For millennials willing to delay gratification for a long period of time, the benefit of a Roth can be meaningful.  While no one can predict marginal tax rates in the future, they will likely be higher over the long term. According to the Heritage Foundation, tax revenues will be fully consumed by 2030.  If so, the government will be forced to raise tax rates in the future.  

If that occurs – and there’s no assurance it will – those who contribute to a Roth will benefit by locking in their current tax rate now.

Avoiding taxes

The rules for withdrawing from your Roth IRA can be complicated.

It’s easy if you don’t make withdrawals until you are 59½ and have met the five-year holding requirement. You can make withdrawals with no taxes or penalties.

You may be subject to taxes and penalties if you withdraw from your Roth IRA before age 59½ and before you have held the Roth for 5 years, although there are exceptions that may permit you to avoid penalties but not taxes.  The IRS has summarized these exceptions here.  They include distributions up to a maximum of $10,000 used in a qualified first-time home purchase, payments made to a beneficiary or estate due to the death of the owner of the Roth and distributions made due to total and permanent disability of the Roth owner, among others.

No required minimum distributions

There are no required minimum distributions (RMDs) with a Roth IRA.  You can let it grow tax-free for as long as you like.

Here’s why this is a big benefit.  When you are required to take RMDs, your income increases, potentially subjecting you to higher taxes.  A higher income may also affect your Medicare premiums.

You avoid these issues with a Roth IRA.

Tax planning

A Roth IRA can help with your tax planning.

Because your withdrawals are tax-free, you can avoid taking distributions from retirement accounts, which will be taxable at your marginal tax rate.  These withdrawals can increase your adjusted gross income, which could increase your tax liability.

While a Roth IRA has many benefits, it’s not right for everyone.  

  • You won’t be able to deduct your contributions.
  • You’ll have to fund your Roth with after-tax earnings.
  • You may not qualify due to income limitations.
  • There are restrictions on withdrawals before age 59½.
  • There is a limit on the amount you can contribute.

If the benefits outweigh the negatives, and especially if you are a millennial, consistent investing in a Roth IRA can be an excellent way to plan for retirement.

Let us help you create a comprehensive, customized financial plan.

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