Is a Roth IRA a Good Idea for Retirement Savings?

Roth IRAs offer long-term tax benefits but there are also distinctive disadvantages that need to be considered before deciding if it's right for you. Learn more about how Roth IRAs work and how they compare with traditional IRAs.

Is a Roth IRA a Good Idea for Retirement Savings?

Roth Individual Retirement Accounts (IRAs) are an ideal retirement savings option for those who are currently in a lower tax bracket than they expect to be in retirement. Millennials are particularly well-positioned to take advantage of the tax benefits of a Roth IRA and the decades of tax-free growth it can provide. Whether or not a Roth IRA is the right choice for you depends on your current income, how much you expect to contribute once you stop working, and your expected tax rate in retirement. With a traditional or 401(k) IRA, you invest with pre-tax dollars and pay income taxes when you withdraw money in retirement.

This means that you will pay taxes on both the original investments and on what they earned. A Roth IRA works in the opposite way: you invest money that has already been taxed at your regular rate and withdraw it with your tax-free earnings when you retire, provided you have had the account for at least five years. If your income is relatively low, a traditional or 401(k) IRA may allow you to get more contributions to the plan as a saver tax credit than you will save with a Roth. This is because a traditional or 401(k) IRA can result in a lower adjusted gross income (AGI) due to pre-tax contributions being deducted from that figure, while after-tax contributions to a Roth are not.

Additionally, if you have a relatively modest income, that lower AGI can help you maximize the amount you receive from the saver's tax credit, which is available to eligible taxpayers who contribute to an employer-sponsored retirement plan or a Roth or traditional IRA. On the other hand, if you choose a traditional or 401(k) IRA, you have to divert less of your income to retirement in order to make the same monthly contributions to the account because Roth would essentially require you to pay both the contribution and the taxes you paid on that amount of income. This gives traditional accounts an advantage in the short term. Another factor to consider is access to income now versus potential tax savings in the future.

A Roth can take away more income from you in the short term because you are forced to contribute in dollars after taxes. In contrast, with a traditional or 401(k) IRA, the income needed to contribute the same maximum amount to the account would be lower due to pre-tax contributions. This increases your financial flexibility by allowing you to make the maximum allowable IRA or 401(k) contribution while still having extra money on hand for other purposes before retirement. If you're married and filing a joint return, your spouse can open their own Roth IRA (a spousal IRA) and fund it separately from your own, even if they don't have any earned income.

The combined income of both spouses is treated the same, even if one spouse generates 100% of the income and the other spouse generates 0%. Roth IRAs offer a long-term tax benefit as tax withdrawals and investment gains are not taxed during retirement. However, there are also distinctive disadvantages that need to be considered before deciding if a Roth IRA is right for you. The key is determining if you expect your tax rate to be higher or lower in retirement.

A Roth IRA is an excellent savings tool for young people who are just starting out since they are likely to start earning more as they advance in their careers and thus face higher income tax rates. It is also effective for those who expect their tax rate to rise in retirement since it allows them to pay taxes now and enjoy tax savings later on. If you don't need your Roth IRA assets during retirement, they can accumulate indefinitely and be passed on as tax-free assets upon death. When deciding between a traditional or Roth IRA, consider factors such as your current income, age, and when you expect to be in a lower tax bracket now or in retirement. In general, a Roth IRA is best suited if you expect your tax rate to be higher in retirement since it allows for greater tax savings. For those looking for additional banking products, check with your bank if your Roth IRA includes them.

If you have multiple retirement accounts, the Roth IRA may be the best option for coronavirus-related distributions since withdrawals come first from contributions. A spousal IRA allows anyone to contribute to an IRA based on their spouse's taxable income, even if they don't have any taxable income of their own. A Roth IRA can be an incredibly powerful financial tool when used correctly and can help prepare for retirement in a tax-advantaged way.