Roth IRAs offer tax-free income in retirement, but they aren’t always the best choice for everyone. Learn when Roth plans make sense for investing toward retirement, and when they don’t.
Pros and Cons of Roth IRAs
Roth IRAs are a popular way to save for retirement because of their tax advantages and flexibility with withdrawals, but there are some downsides to consider as well.
Advantages of Roth IRAs
Tax-free income is an attractive strategy for retirement, and a Roth IRA is one of the few ways you can invest toward tax-free income for retirement.
Savings Grow Tax Free
All earnings in a Roth IRA grow tax free. Traditional IRA earnings grow tax deferred. They’re taxed as income when they’re distributed in your retirement.
Qualified Distributions Are Tax Free
Any distributions from a Roth account are considered qualified as long as the account has been open for at least five years and you’re age 59½ or older. Distributions that aren’t qualified may be taxable and subject to a 10% penalty.
You Can Withdraw Contributions Tax Free at Any Time
Roth IRAs are “first in, first out.” This means that contributions are withdrawn before any earnings. You could withdraw up to $36,000 without tax or penalties if you contributed $6,000 to a Roth IRA for six years.
Flexible Investments
You can use Roth IRAs to invest in a variety of asset types, like stocks, bonds, and even cryptocurrency. But some assets like life insurance and collectibles are not permitted. Your Roth IRA allocations can easily be changed with your investment strategy to reflect your goals and time horizon.
No Required Minimum Distributions
Traditional IRAs and employer-sponsored retirement plans like 401(k)s are subject to required minimum distributions (RMDs). You must start taking withdrawals at a certain age. The amount of the RMD and taxable income increases each year. But you’re not required to take distributions from a Roth IRA and you can keep as much money as you like in your account as long as you live.
Tax Diversification
You may be eligible to contribute to a Roth IRA even if you’re also contributing to an employer-sponsored plan.
Disadvantages of Roth IRAs
Tax-free income is attractive to many investors, but a Roth IRA may not always be the ideal choice for a retirement savings account if your employer offers a plan with matching contributions. Here are some potential downsides to a Roth IRA to consider.
Contributions Are Taxable in the Year You Make Them
Roth IRA contributions are made after tax, which affects your cash flow for that year. For example, you have to earn $7,897 to have $6,000 to invest if you’re in a 24% marginal tax bracket. Traditional plans are tax deductible. You’d only have to earn $6,000 to invest $6,000.
Low Contribution Limits
IRAs have lower contribution limits than employer-sponsored plans like 401(k)s. The maximum contribution to a Roth IRA is $6,000 for 2022, increasing to $6,500 in 2023, while employer-sponsored plans have a limit of $20,500 in 2022, increasing to $22,500 in 2023.. It may not pay to start a Roth IRA if you haven’t ‘maxed out’ your plan at work yet to take advantage of all matching contributions.
They’re Not Available for High-Income Earners
Roth IRA contribution limits are reduced based on your modified adjusted gross income (MAGI). The limits are:
Single taxpayers and heads of household: $129,000 to $144,000 in 2022, increasing to $138,000 to $153,000 in 2023Married, filing jointly: $204,000 to $214,000 in 2022, increasing to $218,000 to $228,000 in 2023Married, filing separately (and you lived with your spouse): $0 to $10,000 in 2022 and 2023
You can’t contribute to a Roth IRA if you are married filing jointly and your adjusted gross income is more than $214,000 or if you are single and your income is more than $144,000.
Rollovers From Traditional Plans Are Taxable
The entire amount is taxable if you want to transfer or “roll over” money from a traditional IRA to a Roth IRA. This can potentially mean a significant reduction in your retirement savings. The rollover could also put you in a higher tax bracket for the year, increasing your tax bill.
Should You Use a Roth IRA?
One of the advantages of Roth IRAs is that you can use them with other types of plans. Here are some things to consider as you develop your retirement savings strategy.
Tax Rates Today vs. Tax Rates at Retirement
Roth IRAs can be ideal if you think your income tax rates will be higher when you retire than they are in the years when you contribute.
How Much Can You Contribute?
A Roth IRA might not be the best choice if you aren’t contributing the maximum to an employer-sponsored plan that offers matching funds. A traditional play may be the better choice if you don’t have a plan at work and your budget doesn’t allow for maximum Roth contributions. The additional money invested in a pre-tax plan could compound into a significant difference over time.
Alternatives to Roth IRAs
You have some other options if you decide that a Roth IRA isn’t right for you.
Standard Brokerage Accounts
A standard brokerage account offers a broad range of investment choices, including individual stocks and bonds, mutual funds, and ETFs. Capital gains and qualified dividends receive capital gains treatment at lower tax rates.
Employer-Sponsored Plans
Many employers offer their employees 401(k) plans or other retirement plans as benefits. Some employers make matching contributions to the plans for their employees. Employer-sponsored plans may also offer Roth options.
Traditional IRAs
Traditional IRAs allow for tax-deductible contributions. You can have as many IRAs as you like, as long as the total contributions don’t exceed the Internal Revenue Service (IRS) annual limits.
Annuities
Annuities are long-term investments that are issued by insurance companies to protect you from outliving your funds by providing a fixed-income stream. They offer tax-deferred growth and guaranteed income. The way annuity withdrawals are taxed depends on whether your contributions were made with pre-tax or after-tax dollars. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
