The Roth IRA Belongs in Nearly Every Financial Plan
Adding a Roth Individual Retirement Account (IRA) to your retirement plan provides you with a wide variety of benefits both now and in retirement. If you don't have a Roth IRA as part of your retirement plan, consider adding one today.
The Difference Between Roth and Traditional IRAs
When you take a portion of your income and invest, there are two taxes you have to pay. The first is the taxes you pay now on your income. You also pay taxes later on the growth of your investments. With IRAs, you get to eliminate one of those two taxes.
Traditional IRAs allow you to take a tax deduction now for funding retirement investments, but you'll have to pay taxes when you retire on the money and the earnings. Therefore, the Traditional IRA eliminates the income taxes you pay now.
The Roth IRA option doesn't provide you with a tax deduction today, but you don't pay income taxes on the money in retirement. Roth IRAs, then, eliminate the taxes you would pay later on the growth of your investments.
Can You Open a Roth?
Even if you contribute to an employer-sponsored plan [like a 401 (k)] you can open and create a Roth IRA. Many mistakenly believe that you can't contribute to a Roth IRA if you have 401 (k), but the rule is that you can't double-dip on the tax deduction. Since Roth IRAs don't give you a tax-deduction today, you can contribute even if you are funding a 401 (k).
Income Limitations Apply
High-income households may be limited in how much they can contribute to a Roth or if they can contribute. If you fall into this category, you can still contribute to a Roth by funding a traditional IRA with after tax money and rolling the money to a Roth IRA.This sounds shady as hell, but as of this writing it's legal. Consult your financial or tax adviser for guidance on if you need to do this and how to do it.
If You have a Roth 401 (k)
Yes, Roth 401 (k)s exist. If you are currently contributing to a Roth employer-sponsored retirement account [like a Roth 401 (k)], then you'll want to open and fund a Traditional IRA instead. Since you don't get a tax deduction on the contributions to the Roth 401 (k), you should still be eligible for a tax deduction from your Traditional IRA.
Why the Roth is so Important
Adding a Roth IRA to your financial plan opens up a variety of new financial tools and strategies. In the present, you will have access to increased contribution limits, greater control over your retirement investments, and the possibility of lowing your investment costs. Once you hit retirement, you also gain access to tax diversification. The addition of a Roth account can also provide you with new strategies for funding an early retirement without paying the associated penalties.
Tax Diversification in Retirement
Diversification is important in every aspect of investing, and diversifying your tax liability is no exception. Probably the biggest benefit you get with a Roth IRA is a pool of money in retirement that is tax-free. Distributions from Traditional IRA and 401 (k) accounts are taxed just like income in retirement. Retirees that contributed all of their money to traditional accounts will have to pay income taxes on all of their retirement distributions during retirement.
If, however, you also contributed to a Roth account, you will be able to choose how much you pay in taxes every year. Assume in retirement you have both a Roth IRA and a Traditional 401 (k) and you want to live on $70,000 per year. If the income tax bracket jumps from 15% to 25% for income over $45,000, you can keep your taxable income below the dreaded $45,001 mark. Simply take $45,000 from your 401 (k) and take another $35,000 tax-free from your Roth IRA.
Increased Contribution Limit
Another benefit of adding a Roth IRA is that it effectively increases your retirement contribution limit. Every tax-advantaged account has a limit to how much money you can contribute each year. If you are only contributing to your 401 (k) account, that account limit becomes the de-facto limit on your retirement investments.
The Roth IRA, however, has its own contribution limit. By adding that account, you can now contribute extra to your retirement, equaling the limit on your 401 (k) plus the limit on your Roth IRA. Your income and other factors may also impact these limits, so check with your financial adviser for your actual contribution limit.
Early Retirement
Another advantage of the Roth IRA is that you can use it to help fund an early retirement. With all retirement accounts there is a minimum age you have to be in order to withdraw the money. If you want to retire early, you generally can't access the money without paying taxes and an additional painful penalty. A Roth also has this limitation, but there is one convenient exception.
Since you already paid taxes on the money you contributed to the Roth account, the money you contributed over your lifetime doesn't count toward these penalties. You can't withdraw the growth of your investments, but all of the money you contributed over your lifetime can be withdrawn at any time without penalty.
Having a Roth IRA means that you could retire early and use part of the money in your Roth account to fund your early retirement. This can provide you an income until you reach retirement age and have access to your Social Security, 401 (k), and other retirement investments.
Greater Control Over and Lower Costs In Your Investments
If you currently only contribute to a employer-sponsored plan, adding a Roth IRA may give you greater control over what you invest in. Most employer-sponsored plans offer a menu of investment options determined by the employer. As a result you are not able to invest in anything you want. Out of the tens of thousands of mutual funds and ETFs you could invest in, your employer-sponsored plan might give you twelve to choose from. On top of that, if you wanted to invest 5% of your retirement account in an individual company, you likely won't be able to buy the stock through your 401 (k).
Roth IRAs, however, are self-directed accounts, meaning you can invest in anything you would like. This allows you to invest in any fund, stock, or other type of asset through your account. You can even invest in your own start-up company or in real estate, although you'll need a financial adviser and a legal adviser to help you do that correctly.
While your 401 (k) limits your choices, an IRA opens up your choices. To add insult to injury, the choices your are limited to in your 401 (k) also generally have higher costs. Every year, a fund takes a management fee equal to a certain percentage of the money you've invested. These fees can range as low as 0.1% to as high as 3% or more. To put that into perspective, if your account is worth $10,000, the fees you are paying to the fund every year could be as low as $10 or as high as $300 or more. That's a big difference in costs, and the difference comes right out of your retirement.
So Why Even Contribute to a 401 (k)?
Free Money
Although a Roth IRA provides you with a variety of benefits, that doesn't mean you should kill your 401 (k). The biggest reason to keep the 401 (k) is the employer match. This is free money that you don't get unless you contribute to your 401 (k). At the very least, contribute enough to get the free money from your employer.
Higher Contribution Limits
401 (k)s and other employer-sponsored plans also have much higher contribution limits than IRAs do. As of this writing, the IRA limit is only $5,500 per year, while the 401 (k) limit is $18,00 per year. That's a big difference in how much you can contribute to your retirement. Additionally, the benefit of adding an IRA is that you get to add the IRA limit on top of your 401 (k) limit. Killing your 401 (k) defeats the purpose.
Tax Deduction & Diversification
The final reason to keep your 401 (k) was the first reason to add the Roth IRA: by funding both, you get two pools of money in retirement to allow you to choose your taxes. This gives you the benefit of the tax deduction now, while also giving you the tax diversification later.
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