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A Basic Guide to the Roth IRA: Tax Pros and Cons

The Roth IRA is a tax-advantageous option for retirement savings. Learn how it works and who should use it.

Key takeaways:

  • Pros:
    • Tax-free withdrawals.
    • Withdraw contributions for any reason at any time without paying tax.
    • Money grows tax-free.
    • Make contributions at any age.
    • No income limits on conversions.
    • Lots of investment options.
    • No required minimum distributions.
  • Cons:
    • No upfront tax benefit.
    • Big tax bill if converting a lot of funds.
    • No tax benefit if your tax rate is lower in the future.
    • Must wait five years to start taking tax-free withdrawals.
    • Maximum contribution of $6,000 is pretty low.
    • Can’t contribute if you are married, filing separately, and make $10,000 or more.

Individual retirement accounts (IRAs) are savings plans provided by banks and other financial institutions that give you a few tax benefits. They’re easy to set up and maintain, so they’re one of the most popular retirement savings options. There are a few types of IRAs, including traditional, Roth, SEP, and SIMPLE. Depending on your situation and goals, there are pros and cons to each of these retirement accounts

Let’s take a closer look at one of the most popular types of IRAs: the Roth IRA. Here is your guide to what it is, the pros and cons, and who might benefit the most from this approach.

What is a Roth IRA?

A Roth IRA is a retirement savings option for individuals, similar to a traditional IRA except for how it’s taxed. These accounts allow you to take tax-free withdrawals when you’re in retirement and receiving the income. This is a big benefit since you don’t have to worry about paying income tax when you could be in a higher tax bracket, relieving a significant financial burden. 

This setup means, however, that the contributions you make now are already taxed, as they’re not tax-deductible like with a traditional IRA. Traditional IRA contributions are usually made with pretax dollars, and you have to pay taxes on the income when you withdraw it in retirement. 

Contributions to a Roth IRA can come from regular contributions, spousal IRA contributions, conversions, rollovers, or transfers. You cannot contribute anything but cash (earned income), so no securities or other assets qualify.

The pros and cons of Roth IRAs

First, let’s review the pros of Roth IRAs:

  • You get tax-free withdrawals.
  • Withdraw contributions for any reason at any time without paying tax.
  • All the money invested in the Roth IRA grows tax-free.
  • You can make contributions at any age when you’re earning income.
  • You can convert a traditional IRA into a Roth IRA with no income limits.
  • You have many investment options, including money market, CDs, mutual funds, stocks, bonds, or ETFs.
  • There are no required minimum distributions in retirement.

Next, the cons:

  • There is no upfront tax benefit—contributions are made with income that has already been taxed.
  • If you have a lot of funds to convert to a Roth IRA, you’ll have a pretty hefty tax bill the year you convert.
  • If your tax rate is lower in the future, you don’t see a significant tax benefit.
  • You have to wait five years to start taking tax-free withdrawals.
  • The maximum annual contribution of $6,000 is pretty low.
  • You can’t contribute if you are married, filing separately, and make $10,000 or more.

To that last point: something many married couples overlook is that you can’t contribute to a Roth IRA if you make over $10,000 and you are married filing separately. If you earned less than $10,000 and lived with your spouse during the applicable tax year, you can contribute a reduced amount. But, it still may make sense to go with a different retirement plan.

Carefully weigh these pros and cons to understand if a Roth IRA is best for you. Compare this type of account with a traditional IRA or a 401(k), both funded with pretax dollars.

Who should use a Roth IRA?

You should consider opening a Roth IRA if you expect to be in a higher tax bracket when you’re in retirement than you’re in now. This means that you’ll ultimately pay less in taxes on the income. Some people also decide to go this route just so they won’t have to worry about paying taxes later, whatever their situation may be. A Roth IRA helps you be proactive about a tax-free future.

Also, it’s important to note that you can’t contribute to a Roth IRA if you make over $140,000 if a single filer and $208,000 for joint filers. So, if you’re above these limits, unfortunately, you have to consider another option.

As touched upon above, there are limits on what you can contribute each year, too. For 2021, the limit is $6,000 if you’re under 50 and $7,000 for taxpayers older than 50. So, if you plan on saving more than these amounts each year, the Roth IRA may not be for you. Or, you’ll need to combine this investment with another retirement plan. (In comparison, a 401(k) allows you to contribute up to $19,500 for 2021).

Getting help from the experts

A Roth IRA can be a very wise choice for many who meet the income requirements and who want to take advantage of tax-free withdrawals in retirement. However, carefully consider all your options.

When you have tax-related questions, contact the team at Provident CPA and Business Advisors. We help you plan to pay the least amount of taxes legally possible. 

Reach out to Provident CPA and Business Advisors today.

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