Setting yourself up for financial security in retirement means considering a number of options for saving and investing.
A Roth IRA (individual retirement account) is one popular retirement savings tool because it can provide a source of tax-free income in retirement. Roth IRAs do not offer tax savings today, but qualified withdrawals in retirement are tax-free. However, they are not ideal for everyone. In some cases, alternatives like 401(k)s or traditional IRAs may be a better choice.
A Roth IRA is funded with after-tax dollars that then grow tax-free within the account. These accounts do have limitations and requirements, and they don’t provide immediate tax advantages. Depending on your situation, you may find an alternative that is more beneficial.
Let’s learn what you need to consider, from your tax bracket to your retirement age, when you’re determining whether you should open a Roth IRA.
- A Roth IRA is an individual retirement account that offers benefits, such as tax-free growth and more flexible distributions.
- In certain circumstances, a Roth IRA may not be the best choice, especially if you can get matching funds with an employer-sponsored 401(k).
- Your current tax bracket, ideal retirement timeline, and income limits are some factors to take into account when you're weighing the pros and cons of a Roth IRA.
The Perks of a Roth IRA
A Roth IRA has the potential to offer significant tax advantages in your retirement years. Contributions to a Roth IRA are made with after-tax income and then you can make withdrawals in your retirement years tax-free, including on any earnings.
Roth IRAs also do not have mandatory withdrawals in retirement the way that traditional IRAs do, and you can withdraw your contributions (not your earnings) at any time with no penalties. You can withdraw your earnings before your retirement age in certain circumstances, such as if you become disabled or if you are using the funds to buy your first home.
You can contribute up to $6,000 of your taxable income, or $7,000 if you are over 50 for 2022.
If you are over 59½ and have held the account for less than five years, you can withdraw your earnings without taxes, which can save many investors a substantial amount.
Many individuals use a Roth IRA for their flexibility with withdrawals because you can take your contributions out anytime, and withdrawals in retirement aren’t mandatory based on age. You can even contribute up to the maximum amount every year you earn income until death and pass the account on to a beneficiary.
When a Roth IRA Doesn’t Make Sense
A Roth IRA has many advantages, yet other retirement savings accounts with different features may make more sense in some situations.
Here are a few scenarios when opening a Roth IRA may not be the best financial strategy.
You’ll Be in a Lower Tax Bracket in Retirement
Consider what your taxable income is likely to be when you retire.
A Roth IRA may not be a good option if you expect to be in a lower tax bracket upon retirement, say if you don’t have the same taxable income from employment. In these cases, you might be better off taking a deduction now with a traditional IRA or other pre-tax account and then paying taxes on your withdrawals in the lower tax bracket upon retirement.
Further, making contributions to pre-tax accounts like a traditional IRA can potentially affect your tax bracket for that year, David Haas, CFP with Cereus Financial Advisors, told The Balance. “[Selecting a retirement account] depends on even whether your income is close to a tax bracket edge where a pre-tax contribution might lower your tax bracket,” Haas said.
Your Earnings Exceed the Limits for Roth IRAs
Roth IRAs have income limits, so you can’t contribute if you earn above the threshold. The IRS uses the following modified adjusted gross incomes (MAGI) as the limits for contributing to a Roth for 2022:
- $214,000 if you’re married, filing jointly
- $144,000 single or married, filing separately (not living with a spouse)
- $10,000 married, filing separately (living with a spouse)
If you earn above the income thresholds, you are not eligible to contribute to a Roth IRA. However, other retirement plans such as a 401(k) or a traditional IRA typically do not have income caps.
One potential way to get the benefits of a Roth IRA if you earn too much to contribute is to use a strategy called a backdoor Roth IRA. With this, you contribute to a traditional IRA, then convert the funds to a Roth, paying taxes at the conversion. This essentially gets around income restrictions.
You Haven’t Maxed Out Your Employer Match
Employers often offer retirement plans with matching 401(k) or 403(b) funds as benefits. If you have this opportunity, it may be a better choice than a Roth IRA.
“Most employers match their employee's contributions, at least up to 5% of their salaries,” Haas said. “If you don't get that match, you are leaving money on the table.” Matching funds are essentially free retirement money you could be getting if you choose that retirement account over a Roth IRA.
Your Time Horizon Is Short
A Roth IRA may not be the best financial decision if you have a shorter timeline for making contributions and needing the withdrawals. A shorter time frame for retirement makes accounts with instant tax benefits more suitable.
Typically, a Roth account needs more time for the earnings to grow so the tax break on them outweighs the taxes you would pay on the contributions.
You need to meet the IRS standards of a qualified distribution to ensure tax-free withdrawals, including that you are at least 59½ years old and the Roth has been open for five years or longer. There are exceptions to the withdrawal tax, such as when:
- You become disabled
- Payment is sent to a beneficiary
- Payment covers a first home purchase
Other Ways to Invest
If your unique situation is not ideal to open a Roth IRA, consider alternative options. Among them:
- Traditional IRA: A traditional IRA is an individual retirement account with deductible contributions and tax-deferred growth. These are often created in addition to or in replacement of an employer-sponsored account.
- 401(k): A 401(k) is an employer retirement account that allows employees to contribute a set amount of their wages to the account. Some employers may offer employer match benefits in which the employer matches up to a certain percentage of the regular contributions.
- 403(b): Tax-exempt organizations can offer employees a 403(b) plan that functions very similarly to a 401(k) plan, including the option for employer-matching funds.
- 457(b): This is an employer-sponsored retirement account for certain government employees that allows them to contribute pre-tax dollars toward retirement. Most notably, a 457(b) does not have a 10% early withdrawal penalty.
The Bottom Line
A Roth IRA, with its tax-free growth and flexible withdrawals, is a valuable savings tool for many people investing toward retirement. For others, it may not be ideal to open a Roth IRA depending on factors like tax status, income, and retirement timelines.
If you’re considering opening an IRA, review your current financial situation, retirement plans, and employer’s offering before deciding. Consider consulting a professional financial advisor who can guide you through retirement savings options that can best fit your specific needs.
Frequently Asked Questions (FAQs)
What is the difference between a Roth IRA and a traditional IRA?
The main difference between a Roth IRA and a traditional IRA is how earnings and distributions are taxed. A traditional IRA takes tax-deferred earnings and then your withdrawals are taxed. Contributions to a Roth IRA are made with taxed income, and then you receive tax-free distributions if you are at least 59½ years old and have held the account for a minimum of least five years.
What is the best type of retirement account?
Roth IRAs, traditional IRAs, and employer-sponsored plans like 401(k)s are popular investment choices for retirement savings. However, which is best for you will depend on your situation and how you prioritize tax-free or tax-deferred earnings. Understanding your tax bracket is a great way to decide what retirement account makes sense for you. For example, if you believe you will be in a higher tax bracket when you retire, a Roth IRA may be a good option.
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