August 6, 2018
August 6, 2018
Of all of the savings, investments and retirement plans out there, the Roth IRA is in a class by itself. Here are five reasons why you need to start a Roth IRA now.
The primary benefit of a Roth IRA is that it can provide you with a tax-free source of income in retirement. The plan is set up such that as long as you are at least 59 ½ years old, and have had a Roth account open for at least five years, the distributions that you receive from the plan can be taken free from federal income tax.
That includes distributions of both your contributions and the investment earnings on those contributions.
Since pensions, most Social Security benefits, and virtually all distributions from other types of tax-sheltered retirement plans will be taxable, the distributions from a Roth IRA will give you at least one source of income without creating a corresponding tax liability.
This may turn out to be more important than you can imagine today. If you will have multiple sources of income in retirement, having at least some of that income be tax-free can be vitally important. It’s even more critical you plan to keep working or running a business during your retirement years. It’s even conceivable that you could be in a higher tax bracket in your 60s and 70s than what you’re in right now.
A lot of people have most or even all of their savings in an employer-sponsored retirement plan, like a 401(k) or a 403(b). It works out well since the contribution limits are extremely high, contributions are automatically payroll deducted into the plan, and often include a generous employer match.
But the downside of that arrangement is having “all your eggs in one basket”. That’s never a good investment strategy.
Having a Roth IRA will provide you with an alternative retirement plan. That will also result in you having more retirement savings than you would have if you were relying strictly on an employer-sponsored plan.
Another disadvantage of an employer-sponsored plan is that they often come with very limited investment options. This is very typical of 403(b) plans, which usually limit your investment choices to insurance annuities. But even many employer-sponsored 401(k) plans might limit you to just a few mutual funds or exchange-traded funds, along with company stock.
This is another area where a Roth IRA can make a huge difference. Since you maintain the account privately, you are free to select any investment broker that you want. You can choose a large brokerage firm, that offers virtually unlimited investment choices. That will give you the option to invest in mutual funds, exchange traded funds, real estate investment trusts, sector funds, or individual securities, like stocks and bonds. Some will even allow you to invest in options and futures if you so choose.
That will give you an opportunity to invest beyond the limited choices available in your employer-sponsored plan. You may even find that the investments that you choose and hold in your Roth IRA outperform those in the employer plan.
There’s an interesting twist in Roth IRA regulations. The IRS Ordering Rules for Distributions for Roth IRAs allows you to withdraw your contributions first when taking early withdrawals from the plan.
That means that if you have $10,000 in a Roth IRA, of which $6,000 represents your contributions, then you can withdraw up to $6,000 from the plan without having to pay either ordinary income tax or the 10% early withdrawal penalty.
While you certainly don’t want to use a retirement plan as an emergency fund, and it should never be your first source of cash, you can use a Roth IRA as a secondary source of emergency cash. You can withdraw the cash that you need, without tax consequences, and then leave the rest in the account to continue growing.
It’s a cool benefit that’s available only in the Roth IRA. It should never be a substitute for having an emergency savings account. But it can serve as a backup plan, in addition to its primary function of saving for your retirement.
The ability to withdraw your contributions from the plan without tax consequences makes a Roth IRA a natural source for a one-time withdrawal of a major purchase, like the down payment on a home.
People often turn to other retirement accounts for down payment money. For example, they might take a loan from a 401(k) plan. But that will mean that they’ll have to make monthly payments on the loan, that will effectively reduce their contributions to the plan.
The other practice is to liquidate retirement assets. They might withdraw money from an IRA, or the 401(k) plan of a former employer. While those can certainly be a source of funds, they come with tax consequences. You will have to include the amount of the withdrawal in your income for that year, and it will be subject to ordinary income tax. Also, if you’re under 59 ½, you’ll also have to pay the 10% early withdrawal penalty.
If you withdraw your contributions from a Roth IRA, you’ll have neither loan payments nor a tax liability. That makes it an excellent source for the down payment on a home.
If you don’t already have a Roth IRA, you should plan to set one up as soon as possible. It’s only slightly more complicated than setting up a bank savings account, but the benefits are so much greater.