The 8 Best Reasons to Invest in a Roth IRA

Posted by Wealth Wire - Monday, March 4th, 2013

When it comes to the family of retirement accounts, the Roth IRA is an investor favorite -- and for good reason.

Roth IRA is a tax-advantaged account that you can use to save money for retirement. But unlike bank accounts, which simply hold the cash you deposit, Roth IRAs let you put your money in growth-oriented investments such as stocks, bonds, mutual funds or ETFs -- all of which can help you make serious headway toward that million-dollar retirement goal you've always dreamed about.

But it gets better. Because you invest after-tax money in a Roth IRA, that money -- plus any earnings-- will be left to grow over time without ever being hindered by taxes. And when it's time to retire, money you withdraw from your Roth IRA won't be taxed by the Internal Revenue Service again. 

That last part alone is a huge advantage over traditional IRAs and 401(k) plans, which both require you to pay federal income taxon every dollar you withdraw during retirement.

All of this means a Roth IRA is not only a great way to build a serious nest egg, but it also can save you literally tens of thousands of dollars in taxes over the course of your retirement.

I'll prove my point. Say I open two retirement accounts today -- a traditional IRA and a Roth IRA -- and start investing $200 every month into stocks in each of the accounts. Assuming both accounts earn an average of 9% per year, each fund would grow to a handsome $936,264 after 40 years, according to our simple savings calculator

Not bad. So what's the advantage of the Roth IRA? Let's say I'm ready to retire and start making withdrawals. If I were to withdraw $50,000 each year from my traditional IRA, that likely would put me in the 25% tax bracket, meaning the IRS would get roughly $12,500 of my withdrawal in income taxes. Ouch.

But with the Roth IRA, withdrawals aren't taxed (as long as I meet the requirements, which I'll explain in a moment), so I can take out my $50,000 per year and not owe the IRS a dime on the back end. It's a great deal. 

Of course that's simplifying a bit. Traditional IRAs have advantages too, which we talk about more here.

But the key difference between a Roth IRA and other kinds of retirement accounts lies in when you're taxed. With "tax-deferred" retirement accounts like traditional IRAs and 401(k) plans, you delay paying income tax on the amount you contribute by having that "pre-tax" money routed to the account rather than going into your paycheck. Instead, you pay income taxes when you take your money out in retirement. The Roth IRA works the opposite way -- you pay taxes like normal when you receive your paycheck before you make a contribution and, in exchange, theIRS lets you take tax-free withdrawals from the account in retirement.

You can probably see by now that the Roth IRA is a stellar retirement tool, but given the different ways retirement accounts are taxed, how do you know if a Roth IRA is the right choice?

Here are eight signs that a Roth IRA may be just the retirement account for you:

1. Your employer doesn't offer a 401(k) planbut you still want to invest for retirement.

Don't let the lack of a company 401(k) plan keep you from saving for retirement. A Roth IRA is a great tool for almost any working person of any age. Whether you're a 16-year-old with a summer job or a self-employed entrepreneur, as long as you earn your income and meet the eligibility requirements, you can save toward retirement with a Roth IRA. 

2. You want to invest in a wider selection ofinvestment choices than your 401(k) plan offers.

With 401(k) plans, you're usually limited toinvesting in the few mutual funds that your employer chose, and often those funds carry expensive fees and a lousy track record of performance. But when you open a Roth IRA through a broker, you can invest in any stock,bondETFoption or mutual fund of your choice. You're also free to sell the investments that aren't working for you tax-free as long as it's all done within the account.

[Need advice on where to start? I talk about an easy way to build your own well-diversified Roth IRA portfolio of ETFs (based on my own) in The Lazy Man's Retirement Portfolio.]

3. You've maxed out your 401(k) plan contributions for the year but you still want to put more toward retirement.

Manage to hit your 401(k) plan's annual contribution limit of $17,500 (as of tax year 2013)? Congratulations! That's a problem many of us wish we had. But in case you want to go for extracredit or you're just looking to catch up in building your retirement fund, look again to the Roth IRA. The amount you can contribute to a Roth IRA is not affected by 401(k) plan contributions, so you can keep putting money into your Roth IRA up to its $5,000 ($6,000 for ages 50+) contribution max long after the 401(k) is filled up.

4. You're not in your peak earning years and you expect to have a higher annual income in retirement.

If you're working part time or expect you'll have a larger annual income in retirement, you can use the Roth IRA to take advantage of your lower tax rate situation right now. For example, if you're currently earning $20,000 per year but you're planning to withdraw $50,000 per year in retirement, you may be best suited with a Roth IRA because you can pay taxes now while you're in a lower-income tax bracket and not have to pay income tax on withdrawals when you're in a higher tax bracket in retirement.

5. You expect income tax rates to rise in future decades. 

Income tax rates are near historical lows -- even with the top tax bracket being 39.6% for 2013. But with the federal government's rising debt and deficits, many aren't holding their breath that taxes willstay low forever. Contributing to a Roth IRA will let you take advantage of today's low tax rates and let you take withdrawals tax-free in retirement -- no matter what happens with future income taxhikes.

6. You want to have penalty-free access to your money in case of emergencies.

While you should try to avoid raiding your retirement fund, sometimes life's unexpected events take priority. If you're younger than 59 ½, you could take a hardship withdrawal from your 401(k) plan and get slapped with taxes and a 10% early withdrawal penalty. Or if you have a Roth IRA, under the IRSordering rules all of the contributions you make may be withdrawn at any time without tax or penalty. So if you contributed $20,000 over the years, you can take up to that amount. Just remember to leave your investment earnings in the account alone -- that part will be taxed and given the 10% penalty. Try to avoid making too many withdrawals though. You don't want your retirement to suffer!

7. You want to leave your heirs with a tax-friendly inheritance.

Some have called the Roth IRA "the best retirement fund to die with" -- and that may not be a farfetched statement. As long as your heirs are labeled as beneficiaries and don't touch your Roth IRA for the five-tax-year waiting period after you're gone, they may take distributions from your Roth IRA without taxation or penalty. And if your spouse is the sole beneficiary, they may take ownership of your Roth IRA and take withdrawals any time after you're gone. In other words, die with a $1 million fortune in your Roth IRA and it won't be long before your spouse or an heir of yours becomes the next family millionaire.

8. You're older than 70 and want to keep building your nest egg.

 Whether you're forced to go back to work or you don't want to quit, it's nice to know the Roth IRA lets you keep saving with tax-free growth toward retirement (or, in this case, much later retirement). With a traditional IRA, the IRS forbids you from making contributions and requires you to start taking minimum withdrawals (called RMDs) after age 70 no matter what. But with the Roth IRA, you're never required to withdraw funds and you can keep contributing regardless of your age.

4 Facts You Must Know About Roth IRA Contributions

According to the 2013 IRS tax rules, here are the basics you need to know about contributing to a Roth IRA:

  • You can't be a high-income earner.You must have a modified adjusted gross income (MAGI) of less than $112,000 per year ($178,000 for married joint filers) if you want to contribute the maximum allowed amount to your Roth for the 2013 tax year. (See further details here.)

  • You can contribute only "earned" income -- money you made from salary, wages or self-employment -- into your Roth IRA. For example, a college student who earned $2,000 from his summer job may contribute up to $2,000 into his Roth IRA.

  • You may contribute up to a maximum of $5,000 ($6,000 if you're older than 50) into your IRAs or Roth IRAs in a given tax year.

  • Before withdrawing your investmentearnings, you must have the Roth IRA open for at least five tax years and be older than 59½ (that is, if you want to avoid a tax bill or getting hit with the IRS' 10% early withdrawal penalty). We talk about certain exceptions to this rule in "5 Safe Ways To Tap Your Roth IRA Before You Retire.For more details on Roth IRA rules, visit the IRS' webpage here.

The Investing Answer: The Roth IRA is one of the simplest, most flexible and universally practical retirement accounts available. There are no tax implications to worry about when you contribute (a blessing during tax time), your nest egg can grow without the headwinds of taxes and when it's time to retire, you can withdraw as much or as little as you'd like. It's as easy as that.

As long as you follow all of the IRS requirements listed in the sidebar on this page, you can open a Roth IRA at any brokerage firm. With online brokers such as TD Ameritrade, Sharebuilder, Scottrade and others, it can take as little as 20 minutes to open a Roth IRA and start investing.

*Post courtesy of Christian Hudspeth at Investing Answers.

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