A Mercer Advisors tax professional highlights various benefits—beyond simple, tax-free growth of assets—of the Roth IRA as a savings vehicle.
What makes the Roth IRA unique among various types of retirement accounts? One distinctive characteristic, among several, is that a Roth IRA owner contributes after-tax dollars. Unlike a traditional IRA, which is a vehicle for tax-deferred growth (i.e., tax is paid when funds are liquidated), Roth IRA assets grow tax-free.
If you think you might be in a higher tax bracket when you retire, the Roth IRA could be extra advantageous for savings. Here are five key benefits:
The most significant benefit of a Roth IRA is being able to save after-tax dollars for tax-free withdrawals in retirement. While a traditional IRA may provide immediate tax breaks because it’s deductible and funded with pre-tax money, a Roth IRA allows tax-free growth of investments. This structure can offer an advantage to a young investor who’s in a tax bracket that’s lower than what it’ll be at retirement. Eligibility for a Roth IRA depends on an income limit set by the Internal Revenue Service, and contribution amounts are subject to phaseout as the individual approaches that limit. For 2023, contributions to a Roth IRA are phased out between $218,000 and $228,000 for married couples filing jointly, and between $138,000 and $153,000 for a single filer. Annual Roth IRA contribution limits in 2023 are $6,500, or $7,500 for individuals age 50 and older.
The rules for required minimum distributions (RMDs) have changed over the years, and with the new SECURE 2.0 Act, the distribution age is now 73 for account owners born between 1951 and 1959. For those born in 1960 or later, the distribution age is 75.
RMDs could be a nuisance if you don’t need them for essential expenses, as they must be calculated and withdrawn every year and may result in taxable income. Additionally, account owners may be subject to penalties if distributions aren’t taken.
A major benefit of a Roth IRA is that minimum distributions aren’t required and your money has more time to grow tax-free, with compound interest on both the contributions and the earnings. Compound interest means that interest is reinvested in the account, enhancing growth. This cycle allows even modest contributions to grow exponentially over time.
RMDs add to income later in life, potentially increasing your tax bill and impacting other obligations such as Medicare premiums. The option to leave Roth IRA savings untouched offers a big benefit over other types of retirement accounts.
Unlike a traditional IRA or 401(k), for which an heir pays tax on any withdrawal, assets from an inherited Roth IRA can be withdrawn tax-free as long as the account has been open for at least five years. Another consideration is that money gifted to an heir won’t be subject to probate, which can make it quicker for them to access the funds.
Designating beneficiaries for a Roth IRA is easy: you can do it when you set up the account. You won’t need to include the Roth IRA in a will or trust. In fact, beneficiary designations take precedence over stipulations in a will. Beneficiaries typically need only their personal identification and a copy of a death certificate to claim an account.
Although Roth IRAs are not subject to RMD rules for the account owner, it’s important to know that they do apply for non-spouse beneficiaries.
You can withdraw original contributions to a Roth IRA tax-free and penalty-free at any time, but you’ll owe income tax if you withdraw earnings from the account within five years of making the first contribution and before turning age 59½. You’ll also owe a 10% early-withdrawal penalty unless one of the IRS penalty exceptions is met. After the account has been open for five years and you’ve turned 59½, earnings can be withdrawn without paying income tax or penalties.
The SECURE 2.0 Act recently added and changed exceptions to the 10% early-withdrawal penalty, including expenses related to terminal illness, hardship withdrawals due to domestic abuse, premiums for long-term-care insurance contracts, and family emergencies.
Many Americans save for college education through 529 accounts. Contributions to a 529 grow tax-free if they’re used for eligible education expenses. Earnings are taxable, and distributions are subject to a 10% penalty if used for unqualified expenses.
New SECURE 2.0 Act provisions allow unused 529 plan funds to be rolled over to a Roth IRA, beginning in 2024, which means they can be used for both college and retirement. Prior to this rule, generally speaking, if a 529 beneficiary completed their education without fully exhausting the account, there were limited options for what to do with the remaining funds. The new 529-to-Roth IRA transfer rule is meant to alleviate concerns about unintended taxation, allowing families to maximize the time value of their money through investing for tax-free growth in college savings. The transfer rule has certain limitations, though, including:
The new 529-to-Roth IRA transfer rule enables greater flexibility in saving for educational needs.
If any of these benefits seems attractive to you, discuss retirement planning with your Wealth Advisor to see if a Roth IRA makes sense for your portfolio.
Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.
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