Why You Should Start Investing using a Roth IRA
The question of contributing to a “Roth” retirement account, either an IRA or a 401(k), is one of the first investing decisions that many professionals need to make when they start their career. The Roth accounts have various advantages that can be utilized by many people for serious long-term financial benefits if they invest under the correct assumptions and circumstances.
Before we get to the reasons themselves, it’s important to understand the differences between a Roth account and a traditional account. A traditional plan allows the investor to deduct the amount contributed during the year against their taxable income, so they effectively aren’t paying taxes on the money they invest when it is contributed in exchange for the principal (the amount invested initially) and the earnings to be taxed in the future. On the other hand, the Roth option allows the investor to elect to have the money taxed before it is invested, in exchange for the principal and the earnings to be tax exempt in the future. Additionally, because each option has tax planning implications, the IRS has rules in place specific to each type of plan that can place a limit on how much investors can contribute.
Today we are going to specifically talk about some of the reasons you should invest in a Roth IRA. It is important to remember that Traditional and Roth IRA accounts have an annual contribution limit per taxpayer, which is $6,000 for 2019 and 2020 across both accounts.
1) Tax Free Growth
As mentioned above, the Roth option allows the investor to pay taxes on the principal amount at the time of investment in exchange for that principal and interest becoming tax exempt in the future (at the age 59.5). This benefit is more valuable when the investor is younger, because the money has more time to grow before it is withdrawn.
2) Tax Bracket Changes
The main consideration between a Roth and Traditional IRA should be the current and expected tax brackets of the investor. Generally, if someone is expected to be in a lower tax bracket when they retire (or start withdrawing at age 59.5), then a traditional IRA works better from a tax perspective because a lesser % of the money is taxed. However, many professions will have you in a lower tax bracket at the beginning of your career, and steadily increase your income such that you are in a larger tax bracket later in life. So, the effect for those people would be a positive one if they choose the Roth route and paid taxes now (for example, in a 24% bracket) instead of later (for example, in a 32% tax bracket).
3) It’s more likely that you can afford it now
Especially if you are starting off in your professional career, you still may be living at home, renting with roommates, or just generally accustomed to a cheaper lifestyle. Under these types of conditions, it will be much easier to set aside the funds to contribute to your Roth IRA. Later on down the road you may have a bit of lifestyle inflation, home repair expenses, and childcare expenses to consider as well. This is particularly important when you consider the effects of compound interest that you won’t need to pay taxes on.
4) Income limits may make the Roth IRA unavailable to you later in life
Like many tax advantages, the IRS sets limits on who can contribute to a Roth IRA and enjoy the tax advantages. In 2019, individuals who file their taxes under the single status can contribute the full $6,000 if their modified adjusted gross income (MAGI) is less than $122,000. Between $122,000 and $137,000, individuals may contribute a portion of the $6,000, but not all of it. And beyond $137,000, the individual is completely ineligible from contributing to a Roth IRA for the year. If you are in a line of work where your income (and therefore your tax bracket) is expected to increase over the years, then you should be taking advantage of the Roth IRA while you are still eligible to contribute to it. This is especially true if your current or future employer has limited Roth or Traditional 401(k) options.
In addition to what we mentioned above, there are some other benefits to a Roth IRA such as being able to withdraw the principal amount at any time without penalty (even before age 59.5) or being able to convert traditional IRA funds into Roth IRA funds.
Remember, you can still contribute to your Roth IRA for the 2019 until April 15, 2020. If you haven’t done so already, there is still time to put that money away for tax free growth! If you have any questions, please let us know in the comments or at scalefinancialeducation@gmail.com.