6 reasons to open a Roth IRA

What is an IRA? An IRA or Individual Retirement Account is a financial account that allows you to save for retirement. There are two types of IRAs that offer tax advantages: traditional IRA and Roth IRA. Contributions to a traditional IRA are typically tax-deductible the year you contribute. Withdrawals from your Roth IRA (in retirement and on other occasions listed below) are not taxed. The type of IRA you contribute to will depend on your personal needs. Plus, it’s always advisable to talk to a tax professional. Before your meeting, make sure you’re in the know about your options. We break down the advantages of a Roth IRA below.

A Roth IRA is a fantastic investment tool for retirement. The flexibility of a Roth IRA can help you accomplish many goals. Do you know all the ways you can use a Roth IRA to your advantage? We’ve come up with six reasons why a Roth IRA could be a good investment for your future.

1. Tax advantages of a Roth IRA

Even if you’ve already maxed out your 401(k), it’s likely you can also contribute to a Roth IRA for even more tax-advantaged savings.¹ You won’t see the tax breaks now. Instead, you’ll get a tax break in the future, as Roth earnings and withdrawals are generally tax-free. Why? Contributions to a Roth IRA are made after your income is taxed. Since you have already paid taxes on this money, you do not need to pay them again as you withdraw. Your earnings can build tax free.

The tax advantages of a Roth IRA are especially beneficial to young earners. You will most likely earn more as you age, which means that your tax bracket will also increase. The benefit to paying taxes now is that your income tax could be at a higher rate in future years.

2. Backup emergency fund

If a crisis hits, your Roth IRA can provide additional emergency funds. Contributions (not earnings) can be withdrawn without penalty.² Plus, withdrawals of contributions are tax-free at any time. Although a Roth is usually used as a retirement account, you will not get penalized for taking out your contributions prior to retirement. This means you could have an emergency fund in case of job loss, injury or anything else unexpected.

3. Fund the purchase of your first home

Use your contributions – and up to $10,000 of earnings – to buy your first home (or to gift your child or grandchild money for their first home).³ Again, this withdrawal is tax-free.

First-time home buyers can use this money if the account has been open for five years and if the funds will be used directly toward the home purchase. That includes the down payment and closing costs. If the funds do not go directly to the home purchase, earnings will be taxed and you will be hit with a 10 percent penalty.

If you’re a young earner, we recommend only doing this if you’ve set aside this Roth IRA for buying a home. If you’re planning to use this money for retirement, you could wipe out a significant contribution that would otherwise grow through decades of compounding interest.

4. Fund your education

Your Roth IRA can pay qualified educational expenses for you, your spouse, your child or your grandchild. As an alternative to a 529 college savings plan, you can set up a Roth IRA to pay for future college expenses. The withdrawal of your contributions for educational expenses is tax-free, as in the scenarios above. However, earnings withdrawals are subject to tax. It’s important that the funds go directly toward educational expenses. If they’re not used for education, you’ll be hit with a 10 percent penalty.

A Roth IRA is also a great way to save for an education because of the spending flexibility. If you do not use all the funds for education, the money can continue to compound until your retirement or be used for other expenses, like the ones we’ve talked about in this article.

5. Control taxable income in retirement

Tax-free Roth funds give you the flexibility to manage your taxable income during retirement, potentially reducing Medicare premiums and income taxes.⁴ Many economists predict that income taxes will rise. If that is the case, then you will be saving money on taxes with a Roth IRA. As we mentioned earlier, your contributions to a Roth IRA are made after income taxes. This means you do not have to pay taxes when you withdraw those contributions. After age 59.5 and five years after you first opened your Roth IRA, your earnings are also tax-free.

6. Tax-free income for heirs

Roth IRAs are a valuable estate planning tool, especially if you have significant savings and may not need all of it to fund your retirement.⁴ Those beneficiaries inheriting a Roth IRA do not need to pay income taxes on their withdrawals (unless your estate is subject to estate taxes). It would be a wonderful gift to the ones you love and would help ensure they are set up for success.

Katie Pins is a marketer fascinated with finance. Whether the topic is about the psychology of money, investment strategies or simply how to spend better, Katie enjoys diving in and sharing all the details with family, friends and Money Mentor readers. Money management needs to be simplified and Katie hopes she accomplishes that for our readers. The saying goes, "Knowledge is Power", and she hopes you feel empowered after reading Money Mentor.

1.    The 2020 Roth IRA Modified Adjusted Gross Income (MAGI) Limit is $203,000 for married couples filing jointly and $139,000 for singles. The 2021 Roth IRA Modified Adjusted Gross Income (MAGI) Limit is $208,000 for married couples filing jointly and $140,000 for singles. Consult with your tax advisor for additional tax information.
2.    You can withdraw any funds you contributed to the account tax- and penalty-free. If your account has not been open for five tax years, withdrawals of account earnings are subject to income tax and early withdrawal penalties (unless your emergency is a qualifying event such as becoming permanently disabled). If your Roth IRA has been open for five tax years, distribution of $10,000 of your earnings to fund a first-home purchase is not subject to income taxes or early withdrawal penalties. If your account has been open for less than five tax years, the $10,000 is not subject to early withdrawal penalties, but it is taxable income.
3.    The IRS defines qualified expenses as "amounts paid for tuition, fees and other related expense for an eligible student that are required for enrollment or attendance at an eligible educational institution."
4.   Consult your tax, financial or estate planning advisors about how you might potentially reduce your taxable income in retirement or about the taxation of your estate, including Roth IRA funds.