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The primary benefit of a Roth IRA is well known. Though you do not get a tax deduction when you contribute to a Roth IRA, the balance grows tax free and qualified distributions avoid tax as well. Along with your workplace retirement plan, Roth IRAs are one of the best ways to save for retirement.
In addition, there are two less well-known benefits of Roth IRAs that make them especially appealing.
First, the principal can come out at any time for any reason. According to the distribution rules on Roth IRAs, it is the principal that comes out first and it is totally tax and penalty free with no strings attached. It’s only the earnings that must stay in until after age 59 ½ and meet other rules in order to remain tax free.
Fortunately, the earnings on Roth IRAs come out last. This means that if you open a Roth IRA today and contribute $7,000, that original “basis” of $7k is available to you, tax and penalty free, even before you reach age 59 ½ or meet the 5-year rule for qualified distributions. What’s more, you can use that money for anything you want. It doesn’t have to be for retirement.
This effectively gives Roth IRAs a similar liquidity and flexibility to brokerage accounts and other non-retirement savings without you having to worry about capital gains or other taxes. Unlike a 401(k) and other workplace retirement plans, you don’t have to wait until retirement to access your funds.
In effect, Roth IRAs become a bridge to retirement since they give you a tax efficient way to save for retirement, but if you do need to get at some of your long-term savings, then the money is there.
For example, if a family emergency suddenly requires you to come up with a large lump sum, you may access the principal in your Roth IRA rather than taking a loan against your 401(k) or taking a taxable distribution from your traditional IRA that could result in additional penalties.
Roth IRAs create a tax-free pool of money that can be used to offset taxable distributions from traditional IRAs or 401(k)s in the future. This is the secret sauce to the Roth IRA and the reason why it is so important to your retirement income plan.
Think of it this way:
A married couple might take $24,800 in taxable distributions from their pre-tax IRA or 401(k) account. Assuming they also take the standard deduction on their taxes, there would be no tax due on that distribution since the standard deduction amount is enough to cover the $24,800 IRA/401k distribution.
If they need additional income, they can take a distribution from the Roth IRA effectively giving them a tax-free income of over (maybe way over) the amount of the standard deduction.
If all your money was in a 401k, only the amount of the standard deduction would be tax free since distributions from 401(K) and traditional IRAs are taxable.
Keeping taxable distributions from retirement accounts low saves you money in other ways as well. Medicare premiums, health insurance subsidies under the Affordable Care Act, and taxation of dividend income and Social Security benefits are all based on your income. Used effectively, Roth IRAs provide a flexible tool to help you manage your total taxable income so that more of your money is available to support your family, your community and the organizations you love.
To discuss any of the topics in this blog or to learn more about how we can help you Cross The Bridge To A Confident Retirement, please contact me through my web site mikebranch.net, call me directly at 651-379-3935 or email me at mpbranch@focusfinancial.com.