In the United States, there are several tax-advantaged ways to save money toward your retirement. One of the most popular options is the Roth IRA. Unlike other individualized retirement accounts, the Roth IRA allows you to contribute post-tax dollars to build profits that are not subject to taxation. The earnings you build in the Roth IRA, including any dividend payments, can be withdrawn without additional taxation.
Like other retirement savings products, there are certain caps to the amount of contributions allowed. There are also penalties that may come into effect if you choose to withdrawal funds from a Roth IRA before you reach the age of 59.5.
If you’re looking for another way to save toward an eventual retirement, here are the pros and cons of a Roth IRA to think about.
List of the Pros of a Roth IRA
1. It provides you with tax diversification options in retirement.
A Roth IRA allows you to take distributions from your retirement account tax-free when you reach the qualifying age. That means you gain tax diversification in your retirement. Roth IRA distributions are not included in your annual income during retirement. That means you can keep your income at a lower income bracket without reducing the amount of cash access you have, potentially reducing your tax liabilities each year.
2. It gives you more money for your retirement.
Let’s say that an individual contributes the maximum amount allowed to a Roth IRA for 30 years. Then let’s compare that to a maximum contribution to a traditional IRA over the same time period. Assuming all investments are equal, the average Roth IRA would provide more than $70,000 extra for withdrawal during retirement, which is 2-3 years of real income for retirees.
3. There are no forced minimum distributions from a Roth IRA.
With a traditional IRA, you are forced to begin taking money from the account at the age of 70.5. When you contribute to a Roth IRA, the rules are different. You do not have required minimum distribution rules to follow. That means you can leave your IRA to your family if you don’t need to touch it during your retirement. Under current rules, that would allow the heir to continue building the account over their lifetime tax-free as well. As with all tax rules and regulations, however, this benefit is subject to change if Congress addresses the issue.
4. You can withdraw your contributions.
With a Roth IRA, you are permitted to withdraw your contributions without penalty. You are not permitted to withdraw your earnings without a penalty. That means you can use your Roth IRA as an emergency backup for your finances should the need arise. If you find yourself running a little short when trying to make a down payment for a house, for example, you could pull some contributions out of the Roth IRA to make up the difference.
5. There are some exceptions to the taxation rules.
Under the current tax structures, you can withdraw earnings from your Roth IRA without being subjected to taxes on the amount if you meet certain conditions. You can withdraw up to $10,000 in earnings if the account is 5 years old or more for a first-time home purchase. You’re also permitted to take earnings withdrawals if you become disabled or must pay for unreimbursed health insurance expenses or medical costs.
6. You can participate in a Roth IRA and your employer’s retirement plan.
Contributing to an employer’s retirement plan does not exclude you from contributing to a Roth IRA at the same time. That means you can create multiple income streams for yourself in retirement, including a pension and a 401k, assuming you meet the income requirements that are in place for the Roth IRA. The overall income limits in this scenario are much higher when compared to a traditional IRA as well.
7. There isn’t a maximum age limit for contributions.
You are permitted to continue contributing to a Roth IRA at any time. With a traditional IRA, you can no longer contribute to the account after you reach the age of 70.5. That means if you take on a part-time job or you don’t need to use your full pension at the age of 76, you can still make contributions to the Roth IRA to continue building your overall wealth.
8. The Roth IRA qualifies for the Saver’s Credit.
Although there isn’t an immediate deduction for contributions to a Roth IRA, this retirement savings option does qualify for the Saver’s Credit in the 2017 tax year. If your adjusted gross income is $62,000 or less, then you can qualify for a credit of $1,000 per person (which means $2,000 for married couples filing jointly) when making an eligible contribution to a Roth IRA.
9. You can convert a traditional IRA into a Roth IRA.
With a Roth IRA conversion, you can create a better retirement income stream because you can convert a tax-deferred amount into a tax-free amount for withdrawal at a later time. You no longer need to deal with the ratios between deductible and non-deductible contributions when a conversion takes place either, which means the entire converted balance from a contribution standpoint becomes available to you in case you need to access the funds in an emergency.
List of the Cons of a Roth IRA
1. The overall contribution caps are somewhat low.
For the 2018 tax season, you will be permitted to contribute up to $5,500 to a Roth IRA. For contributors who 50 years of age or older, they are permitted an additional $1,000 in contributions for “catching up” on their retirement. Although these limits are the same with traditional IRAs, there are other retirement options which have higher contribution caps. A 401k, for example, could receive up to $18,000 in contributions, with $6,000 catch-up limits, in 2017.
2. You pay your taxes before you make your contribution.
When you contribute to a Roth IRA, you are not able to take the tax deduction which comes from other retirement products. Although this post-tax contribution does provide some long-term advantages for individuals, it does make it difficult for some households to make regular contributions to their retirement account.
3. You are responsible for funding your Roth IRA.
Most administrators of a Roth IRA will allow you to setup an automatic contribution from an authorized bank account to make it easier to fund your retirement account. Not every provider, however, may offer this option. If you don’t have automatic payments available, then you must initiate each transaction into your IRA. In comparison, many employees can directly contribute to a 401k plan from their paycheck automatically and receive an employer match on their contribution.
4. You must meet income limits to qualify.
High income earners may not even qualify for a Roth IRA. Eligibility requirements are subject to change in every tax year. For the 2018 tax year, married couples filing jointly, or qualified widows and widowers, must have a modified adjusted gross income of $189,000 or less to make a maximum contribution. A modified AGI of $199,000 or more excludes these households from the Roth IRA completely. For single filers, heads of household, or those who are married and filing separately, a modified AGI of less than $120,000 is required to maximize contributions.
5. You can only contribute taxable earnings to a Roth IRA.
If you have earnings that are not taxable, then you are not permitted to contribute to a Roth IRA under the current tax rules. For households that have less than $5,500 in taxable income each year, the amount they are allowed to contribute is capped at the amount of taxable compensation that was received. Even if you can only contribute a reduced amount, however, you should consider doing so because of the tax advantages which are available.
6. Contributing too much in a year can generate a penalty.
If you contribute more that you’re permitted in a Roth IRA in a single year, then you’ll pay a 6% penalty on the extra contributed to the retirement account for every year it remains in the account. You are permitted to backtrack an excess contribution to avoid the penalty. Even if you’ve already filed your taxes for the year, you can remove the extra contributions within six months of your filing date, file an amended return, and eliminate the penalty. You’ll still pay taxes on any earnings generated, however, during that time.
7. The Roth IRA must be open for 5+ years to receive certain benefits.
If you take a distribution of Roth IRA earnings before the account is 5 years old, even if you are at the required age for an authorized withdrawal, you are subject to a potential penalty on an earnings distribution. There are some exceptions to this rule, such as making a down payment on a first-time home purchase or the withdrawal is used to pay for unreimbursed medical expenses. If you meet the age requirements, you won’t face penalties, but you will pay taxes on your earnings.
8. Rising income levels can exclude future contributions.
If your annual income for a tax year is higher than the permitted amount for a Roth IRA, then you are not allowed to contribute to it. That means you can be eligible in some years to make contributions and ineligible in other years. If you do make contributions to the Roth IRA in a year when you are ineligible to do so, the funds would be treated as an excessive contribution. You would need to withdraw the funds within the permitted period to escape the 6% penalty assigned to the amount. For those with an income that hits right around the cut-off line, it can become difficult to decide which retirement option is the most advantageous.
9. You must pay taxes on the amount converted in a Roth IRA conversion.
If you have $50,000 in a traditional IRA and you wish to convert it to a Roth IRA, then you’ll pay taxes based on the income bracket you happen to be in. The example typically used is for a taxpayer in the 15% tax bracket. By making the conversion, you will receive an income tax bill of $7,500 that must be paid, plus any state income taxes which might apply to the balance. The only benefit to the conversion is that you won’t pay the early withdrawal penalty. The conversion can even push you into a higher income tax bracket, which may further increase your tax liabilities.
The pros and cons of a Roth IRA offer another alternative for retirement income that offers some current benefits too. Not only can you withdraw contributions without penalty right away, you may be able to withdraw earnings too for certain activities. There are certain income limits that may exclude some households from qualifying, however, so it is important to weigh all your options before settling on a specific retirement savings product.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.