There are a lot of ways you can save for retirement. There are 401(k) plans, provided through employers, and IRAs, which you can open on your own. Drilling down further, there are two classifications of those accounts: traditional and Roth.
While a traditional account allows you to save money pre-tax, a Roth account is funded after-tax. Paying taxes sooner rather than later may not sound beneficial, but depending on your specific situation, it absolutely can be, as many younger savers are starting to realize.
In recent years, the “youngest savers are flocking to Roth individual retirement accounts,” with Gen Z in particular embracing Roth IRAs, said The Wall Street Journal. “Overall, IRA contributions for people of all ages hit record highs in the first quarter of this year, with nearly 30% more dollars flowing into these accounts than in the same period last year.”
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What benefits do Roth IRAs offer?
Because you pay taxes on the money you put into a Roth IRA, that means you do not have to pay taxes later. As a result, “your money grows tax-free, and you’ll be able to withdraw it tax-free at retirement,” said Bankrate. Plus, if you are in a lower tax bracket now than you expect to be when you are older, you will end up paying a lower rate.
Another perk is that the Roth also can do “double-duty as an emergency account,” said the Journal. This is because Roth IRAs allow withdrawals of your contributions penalty-free (there are, however, stipulations for withdrawing earnings). And if you do not end up needing the money immediately in retirement, Roth IRAs do not have required minimum distribution (RMD) requirements like traditional 401(k) and IRAs do.
When you eventually take out money in retirement, those tax-free withdrawals can help “supplement taxable income without moving into a higher tax bracket or triggering costly Medicare premium surcharges,” said the Journal.
Are there downsides to Roth IRAs?
The “most obvious disadvantage of contributing to a Roth IRA is that your contributions are made with after-tax dollars,” which “means you won’t get a tax benefit in the year you make the contribution,” said Bankrate.
There are also restrictions on who is eligible to contribute. Those whose income is above a certain level (adjusted each year for inflation) are technically not able to contribute to a Roth IRA, though there is the workaround of the backdoor Roth IRA.
Who can a Roth IRA make sense for?
“Most advice on the Roth IRA vs. traditional IRA topic begins with a question: Do you think your tax rate will be higher or lower in the future?” said NerdWallet. Generally speaking, a Roth IRA can make sense for those who are just starting out in their careers. This is because earnings are typically lower at that point, meaning a lower tax bracket, and because you are less likely to run up against income limits for contributions.
There are other advantages worth weighing as well. For instance, a Roth IRA could make sense if you want to use the funds for a “home purchase or for higher education expenses” due to “certain exceptions to Roth IRA early withdrawal penalty rules,” said Experian.
You might also consider a Roth account even if you already have a traditional account, whether a 401(k) or IRA. Since the two types of retirement plans offer different tax benefits, having both can diversify your retirement tax picture.
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