4 Advantages of Roth IRAs as Part of Your Tax Planning Strategy

The last few weeks have been a bumpy ride for most investors in the stock market. The market volatility in 2022 has many investors rethinking their investment strategy and looking at other viable investment tools, including Roth IRAs.  From a tax strategy standpoint, this is usually when you should consider converting some of your retirement money into Roth IRAs.

Roth IRAs are tax-favored accounts where qualified taxpayers can make after-tax contributions. Contributions to the account can grow tax-free, and neither the contributions nor the earnings are subject to tax when a Roth IRA owner receives a qualified distribution from the account.

Although Roth IRAs are designed to help taxpayers save for retirement, it is inaccurate to describe a Roth IRA as just a retirement savings vehicle. A Roth IRA can offer tax, estate planning, and financial planning advantages that are not available with a traditional IRA.

Roth IRAs offer several advantages over traditional IRAs.

1. An individual can contribute to a Roth IRA regardless of age.
2. Distributions can be made entirely tax-free, as long as they are qualified distributions (generally, distributions made more than five years after the contribution that are made after the owner turns 59½ years old, died, or become disabled, and distributions for specific purposes, including purchasing the first home).
3. The Roth IRA owner is not required to take lifetime distributions so that the tax-free buildup can continue throughout the owner's life.
4. Distributions of contributions are always tax-free, no matter when they are made.

Distributions from a traditional IRA are fully taxable, except to the extent they represent the return of after-tax contributions. A traditional IRA is subject to the minimum distribution rules, so the owner must begin receiving distributions in the year following the year in which the owner turns 72 (70 ½ if you reach 70 ½ before January 1, 2020) and take them over a prescribed period.

A taxpayer that decides to take lifetime distributions can benefit from the same favorable tax treatment accorded to Roth IRAs. Like traditional IRAs, Roth IRAs provide for tax deferral on the earnings. No tax is imposed as long as the distribution is qualified; this benefit is increased as discussed above.

Another benefit of the Roth IRA is that the owner is not required to take distributions, which makes Roth IRAs beneficial estate planning tools if you do not need the funds in the account. You can leave the account intact for your heirs, thereby maximizing the tax-free growth of the account. By not taking distributions from the account, you will, upon death, pass on a larger amount to your heirs than if you had been required to take distributions from the account. Additionally, a beneficiary of a Roth IRA is permitted to take distributions from the account over a period not exceeding the beneficiary's life expectancy. This allows the tax deferral to continue after the original owner's death if the beneficiary does not need the funds immediately (and the Roth IRA owner can maximize this by naming a young beneficiary). Finally, the distributions are tax-free when received by the beneficiary.

The fact that you can withdraw the annual contributions made to the Roth IRA at any time without incurring any tax means that these accounts can serve financial planning goals that a traditional IRA cannot. Before contributing to a traditional IRA or other retirement plans, it is essential to ensure you can afford to be without the funds for some period of time since tax and heavy penalties are imposed when funds are prematurely withdrawn. However, in the case of a Roth IRA, withdrawals, before the five-year requirement is satisfied, are tax-free as long withdrawn funds come from contributions. As a result, a Roth IRA can act as an emergency fund since you can make tax-free withdrawals from the account to the extent of the contributions made to the account.

Distributions from a Roth IRA come from the money you have contributed first. For example, assume you contribute $3,000 to a Roth IRA in Year 1, Year 2, and Year 3. In Year 4, when the account is worth $11,000 (contributions plus earnings), you need $5,000 for an emergency. Since you have contributed $9,000 to the Roth IRA, you could withdraw $5,000 tax-free from the Roth IRA. You must keep accurate records of the contributions made to a Roth IRA, especially in the case of a withdrawal. You will need to show that the money you withdrew from the account came from contributions you made to remain tax-free.

Contact our team to discuss the tax advantages a Roth IRA can provide you.