You love saving money on taxes. I love saving money on taxes. Who doesn’t love saving money on taxes?
It’s that time of year when we all cram tax rules into our brain and forget them in April. You have until Tax Day (April 18, 2016) to make 2015 contributions to a Roth IRA.Here are five benefits and one downfall of a Roth IRA.
Two quick warnings. First, keep in mind this information is updated for the 2016 tax year. Second, a Roth IRA is not the same as a Roth 401k or Roth TSP (but they do have some similarities). For complete and up-to-date retirement account rules, visit IRS.gov.
1. Tax-Free Retirement
The best reason to start a Roth IRA is to use your money tax-free during retirement. This is different than other retirement accounts because you pay income taxes as the money goes in.
If your account is 5 years old and you are older than 59 ½, you can take money out of a Roth IRA without paying any extra income taxes.
2. Tax-Free Growth
After you contribute to a Roth IRA, your money can be invested in different securities. Your investments can grow without affecting your income taxes.
This means that capital gains, dividends, interest, and other transactions are invisible to income taxes.
When you decide to pull money out of the account, then you need to be careful of the tax rules.
3. Other Tax-Free Money
The money that is used to contribute to a Roth IRA is considered “after-tax money.” Meaning you have already paid income taxes. You contributions can be withdrawn at any time without being taxed or penalized.
Example: You contribute $5000 and after a while it grows to $6000. You can take out $5000, tax-free, whenever you would like. But if you withdraw that extra $1000 of growth, it could be taxed or penalized (depending on your situation).
4. Special Situations for Penalty-Free Money
There are times when you might need to use your Roth IRA money for something other than retirement. Usually, this is called an early distribution, and you would be taxed on earnings and pay an extra 10% penalty.
But the IRS has some exceptions that allow you to withdraw penalty-free money from your Roth IRA. Some of these are:
- Total and permanent disability
- Buy, build, or rebuild a first home
- Health insurance while unemployed
Keep in mind, I did not say the money is tax-free. And there are more special situations than these. To see the full list, visit IRS.gov.
5. Tax-Free Income for Your Family
When you die, the money in your Roth IRA can go to your beneficiaries in different ways. The default option is for your beneficiaries to take out all the money within five years of your death, tax-free. Yet, there are some other options.
All beneficiaries (that are an actual person) also have the option to open an “inherited IRA.” From there, they can withdraw annual, tax-free distributions based on their age. The IRS calls these Required Minimum Distributions (RMD).
Your beneficiaries can stretch these payments over their entire life while leaving money in the account to be invested and grow. These amounts are calculated by the IRS and withdrawing more may cause taxes or penalties.
Finally, your spouse also has the option to roll over your Roth IRA into their Roth IRA after you’re gone. He or she can then treat your money as their own.
6. No Income Tax Deductions
The weakness of a Roth IRA is the lack of a tax benefit today. Unlike the traditional 401k, TSP, or IRA accounts, you don’t get to deduct your contributions from income taxes. So if you need a break from taxes this year, contributing to a Roth IRA won’t help you out.
As you can see, choosing between a Roth IRA or other retirement accounts can be confusing. Check out my other articles for more info on making better money decisions for you and your family.