If you’re saving for retirement in a 401(k) or other workplace plan, kudos to you. You’ve taken a major step toward a more secure retirement. But don’t stop there.
Because of their unique benefits, consider investing in a Roth IRA, too.
Why should you complicate your life with another retirement account? We’ve got three good reasons:
1. Tax-free growth
One advantage of Roths is tax-free growth. You put money in after you’ve paid taxes on it, and no other taxes are levied on the account (assuming you don’t withdraw your earnings early). Your money then grows tax-free, which frees you from worrying about how your years of investment growth will be hit with taxes in retirement — a liberty traditional 401(k)s and IRAs cannot provide.
“The Roth IRA removes the uncertainty of what future taxes can do to your retirement account,” says Ed Slott, a certified public accountant and founder of IRAHelp.com.
When you retire, your Roth earnings will be exempt from taxes, while your traditional 401(k) earnings won’t be. That is, any money that comes out of a Roth after you retire will be tax-free, while money from your traditional 401(k) or IRA will be taxed. Your Social Security benefits may be taxed, too, so your retirement tax bill may be higher than you think.
Given the uncertainty of your tax situation decades into the future, it makes sense to hedge your bets with a traditional 401(k) and a Roth. Check out Roth eligibility rules to see if you qualify.
2. Flexibility as you save
Another big benefit of Roths is you can withdraw your contributions anytime, without taxes or penalties. If you pull out investment earnings early, however, you’ll owe taxes and penalties on that money.
“The first and foremost reason [to invest in a Roth] is the flexibility of distributions,” says Michael Bucci, senior manager of investment strategy for retirement plan services at Schneider Downs Wealth Management Advisors in Pittsburgh.
In fact, a Roth IRA can act as a backup emergency fund. For immediate emergencies, you want money in a savings account, not the stock market. But in the event of a long-term job loss, for example, having a Roth can be a blessing.
3. Tax diversification
Once you reach retirement, you might be grateful your Roth lets you manage your tax bill at a time when your income is less flexible.
Given the taxes you’ll owe on traditional 401(k) and IRA payouts, tax-free money from your Roth can act as a buffer that lets you avoid a higher tax bracket.
The experts call it "tax diversification." When you’re retired, if your traditional 401(k) or IRA withdrawals are about to bump you into a higher tax bracket, yet you still need more money, you can withdraw from your Roth.
“You can choose which account to pull from year to year, depending on where you fall in the income level or where tax tables are as a whole,” Bucci says.
Your tax-free Roth withdrawals also can help reduce taxes on your Social Security benefits. Depending on your income, either 50% or 85% of your Social Security benefits may be subject to tax. The calculation is based on a specific income threshold. If your income is over that amount, you may get bumped into paying taxes on more of your benefits. For more on how it works, check out this Social Security Administration page.
But taking income from a Roth rather than a traditional IRA or 401(k) may prevent you from hitting that higher threshold where 85% of your benefits are taxed.
“You cross that threshold and — boom — your income taxes go up,” says Kelly Wright, a certified financial planner and director of financial planning at Pinnacle Advisory Group in Columbia, Maryland.
Instead, he says, let your Roth step in and provide that income. A previous version of this article mischaracterized the potential tax impact of drawing income from a pretax retirement account. This article has been corrected.