A Roth IRA is an individual retirement account that is funded with after tax dollars. It is arguably one of the best investment vehicles to invest within mainly due to its tax efficiency and flexibility for retirement savings. But there are a couple of additional benefits to the Roth that are less understood and less talked about that are worth your time to better understand.
If you don’t have a Roth IRA, consider and digest these 4 key benefits of a Roth IRA below to determine if it may actually be a good fit for you and your financial future.
What Are the Benefits of a Roth IRA?
1. Tax Free Growth & Withdrawals
The Roth IRA is most well known for its tax free nature. The process goes a little something like this…
- You open a Roth IRA and contribute after tax dollars into the account
- You invest the funds within the account and watch them grow for years to come
- Any earnings and growth within the account will grow tax FREE over time
- Upon time to withdraw the funds after age 59 1/2, the distributions will be tax free (so long as you’ve held the account for a minimum of 5 years).
Tax free growth is POWERFUL and eye opening when you look at the impact on an account over a long period of time.
Here is an example:
Sally contributes $6,000 (after tax) to a Roth IRA (or Roth 401K) and Joe contributes the same (pre-tax) into his Traditional IRA (or 401K) from age 20-30 and they never touch the account again until age 60.
Assuming an average annual rate of return of 8%, both Sally and Joe will have roughly $1,000,000 in their respective accounts by age 60.
At age 60, they both would like to take $100,000 out of the account for their own individual reasons.
Sally walks away with $100,000, tax free.
Joe walks away with roughly $75,000
- This assumes an average tax rate of 25% for illustrative purposes but will ultimately depend on Joe’s total ordinary income tax rate and other income sources
- Note that Joe’s initial contributions did not pay any tax, where Sally’s did. However, the approximate $960K of growth is the most meaningful difference as the Roth IRA grows tax FREE….and the traditional IRA does not. This tax free growth has a meaningful impact on wealth over time.
Note: Keep in mind, that you are able to withdraw your original contributions from a Roth IRA at any time, tax and penalty free.
2. Flexibility in the Use of Roth IRA Funds
The Roth IRA allows for complete flexibility in the way your investment funds are used so long as you wait until age 59 1/2 to withdraw the earnings and growth within the account.
There are a few other tax free investment accounts that are made available to investors but they limit the use of the funds for specific purposes – like a 529 college savings plan to be used only for qualified education or a Health Savings Account to be used specifically for qualified medical expenses.
The Roth IRA does not have any limitation on the way the funds are used and offers complete flexibility in that regard.
Some of you may be skeptical about having to wait until you are 59 1/2 to use the funds – but there are a few ways to withdraw the funds prior to age 59 1/2 without having to face tax or penalties. See below for a few qualified distributions and visit the IRS website to learn about more.
- First Time Home Purchase: Up to a $10,000 lifetime maximum
- Qualified Education Expenses
- Qualified Expenses Related to Birth or Adoption
- Disability or Death
- Unreimbursed Medical Expenses or Health Insurance if Unemployed
3. A Great Wealth Transfer Tool
Unlike traditional retirement accounts, the Roth IRA/401K does not have required minimum distributions. Per the IRS guidelines, you are typically required to withdraw a certain percentage of your retirement account balance per year starting at age 72. Upon this distribution, you will be taxed at ordinary income tax rates.
But not the Roth IRA.
The Roth structure allows your funds to continue to grow tax free with no requirement around having to withdraw the funds. Meaning that your account could effectively continue to grow and grow tax free until you are 100 years old.
For those with significant wealth, you may consider this as you continue to navigate how to be most tax efficient with your wealth.
For many others, you might ask why would I save for retirement if I won’t end up needing the money? Or why would I care if I can transfer it effectively, I want to use it?!
Here’s the thing, none of us – not a single one of you – know what the future holds. You don’t know the money or opportunity that will be presented to you years from now. You may just find yourself in a position that your Roth IRA account will be in excess of your needs.
So it is nice to know that if you prioritize your Roth IRA, it can continue to grow tax FREE for years to come without any rulings that state the funds are to be withdrawn and placed into some other taxable account.
4. Avoid Double Taxation Upon Death
The Traditional form of retirement account is one of the most tax inefficient ways to pass on wealth to the next generation if you have substantial wealth. This section will be specific to high net worth individuals, but still valuable to understand.
- If you pass away with a Roth IRA account, your listed beneficiaries will receive the funds from the Roth IRA and make withdrawals over time tax FREE.
- If you pass away with a Traditional IRA or 401K, your listed beneficiary will receive the funds from the account and make withdrawals over time that will be taxed at their ordinary income tax rates.
But let’s add a level of complexity here….
Let’s say you have significant wealth. Imagine you have $20 million dollars to your name and then pass on these accounts to your children (this does not apply to a spouse to spouse transfer).
The IRS and potentially your state will want a piece of that net worth you are passing down. Enter the Estate Tax. If you have a significant amount of wealth, the IRS may expose your assets to an up to 40% estate tax and the state will have its own set of rules and rates.
- If you pass away with a $20 million estate, and a Roth IRA is part of that estate, you may face an up to 40% IRS Estate tax on your assets. Your beneficiary will then continue to receive the Roth IRA and take tax free withdrawals moving forward.
- If you pass away with a $20 million estate, and a Traditional IRA or 401K, you may face an up to 40% IRS estate tax on your assets AND when your beneficiaries withdraw the funds from the IRA, they will be taxed again at their ordinary income tax rates.
This double taxation will eat away at a significant portion of your wealth that you have created in the hopes to pass down to the next generation. It’s important to discuss with a tax advisor on how to be most tax efficient with your assets as they are transferred.
Note: The IRS does provide a federal tax break for these scenarios and may allow an IRA beneficiary to offset some of the income charged on the taxable IRA distribution by the amount of estate taxes attributable to the IRA. Consult a tax advisor if you have further questions on this.
Note: Among high net worth families, it may be worth considering a Roth Conversion for your traditional retirement assets to avoid this double taxation of your assets.
There are many benefits to the Roth IRA…
…that make it not only a wonderful tax free retirement savings, but also an incredible opportunity to build tax free wealth for your family in years to come.
Refer to a past blog post on Roth IRA’s for more information.
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