Why is the Roth IRA gaining so much attention?

Wouldn’t it be amazing if you didn’t have to work for a living? Whether you're early in your career or closer to retirement, it's never too soon (or too late) to start planning for the future. The sooner you start, the sooner you could retire—or the wealthier you will be when you do. The Roth IRA is an exceptional investment option, and if you qualify, it's a must-have.

Chances are, you've heard of Roth IRAs (Individual Retirement Accounts)—especially since financial experts can’t stop talking about them. And they’re right to do so—it's a fantastic option if you begin saving early.

It’s important to note that a Roth IRA differs from a traditional IRA. While we've broken down the different types of IRAs here, the two most common are the Traditional and Roth IRAs. The distinction between the two can be a bit tricky, but here’s the essence of it:

• The Traditional IRA is tax-deferred. You can deduct the amount you contribute from your taxable income each year, meaning you’ll pay less in taxes now. However, when it’s time to withdraw the funds in retirement, you’ll be taxed on the withdrawals.

• The Roth IRA offers tax-free growth. While you can’t deduct your contributions from your income like you can with a Traditional IRA, when you withdraw the funds at retirement, you won’t pay taxes since you've already paid them upfront.

One of the main reasons financial experts and investors are so enthusiastic about the Roth is its tax-free growth, but that's just one of its many benefits. Let’s dive deeper into each of its key advantages.

Your money grows without being taxed.

When choosing between a Roth and a Traditional IRA, here's a simple rule of thumb: if you anticipate being in a higher tax bracket when you retire, opt for a Roth. You'll pay taxes now, but at a lower rate since you’re likely in a lower bracket today.

With a Roth, the money you earn through investments is also tax-free, as long as you’re withdrawing the earnings during retirement. This makes the Roth especially advantageous if you start contributing early in your career. The earlier you begin, the more your money can grow, and by paying taxes now, you’re saving money for the future since you'll likely be in a higher tax bracket when you retire. Keep in mind, there are income limits for contributing to a Roth. Once your adjusted gross income exceeds $116,000, your contribution limit decreases. So, it’s smart to start contributing while you’re still eligible.

The Roth’s tax benefit also provides a hedge against potential tax increases. While we can't predict if federal tax rates will rise in the future, if they do, you've already paid taxes at a lower rate with your Roth.

You Have Greater Access to Your Funds

With a Traditional IRA, you can withdraw your contributions early without incurring a penalty, but only for specific reasons, such as buying your first home. However, you will still be required to pay taxes on that money since it was tax-deferred.

In contrast, with a Roth IRA, you don’t need a special justification to access your contributions. You can withdraw the funds you’ve contributed at any time (though you can’t touch the earnings yet). There’s no penalty, and you won’t owe taxes (since you’ve already paid them!). This liquidity is a significant benefit.

For instance, imagine you’ve always dreamed of moving abroad, and you’re saving up for a possible relocation. You’re unsure when you’ll need the money or even if you will need it (maybe you’ll land a job there), but you’re preparing for a move within the next five years. While you could use a taxable investment account for this medium-to-long-term goal, a Roth IRA might be a better choice. By saving in a Roth, you get both the return on your investment and tax advantages, plus it’s penalty-free if you need to withdraw the funds for your move. This flexibility is not available with a Traditional IRA.

It’s not advisable to borrow from your retirement savings, but this isn’t borrowing; it's simply parking your savings for a non-retirement purpose in your Roth IRA. If you're looking for a place to save money for a goal, a Roth account provides a flexible, tax-advantaged option.

You May Be Eligible for the Saver’s Credit

Another tax advantage of the Roth IRA is the “Saver’s Credit.” This is a tax break for individuals with low to moderate incomes who contribute to a Roth IRA. Depending on your income, you can receive a credit of up to 50 percent on the first $2,000 you save in your IRA, meaning you could reduce your tax bill by as much as $1,000.

However, there’s an important caveat to remember: this is a “non-refundable credit,” which means it will reduce your tax liability to zero, but you won’t receive a refund. Additionally, there are income limits. Here are the thresholds for 2015, according to the IRS:

Many taxpayers don’t realize this credit exists. Granted, if your income is low to moderate, you might not be in a position to save much for retirement. But if you qualify and can manage to save even a small amount, this is definitely a benefit to take advantage of.

There Are No Required Minimum Distributions

With most retirement accounts, once you hit a certain age, you’re required to withdraw a specific amount of money. This is known as a required minimum distribution (RMD). The problem is, you may not need all that money, and withdrawing it means you’ll have to pay taxes, which could push you into a higher tax bracket.

This isn’t an issue with the Roth IRA, as it doesn’t require a minimum distribution. You have the freedom to withdraw as much or as little as you want each year.

The “Backdoor” Roth IRA for Those Who Don’t Qualify

Unfortunately, not everyone fully qualifies for a Roth IRA. For 2015, you can contribute up to $5,500 to your Roth if your income is below $116,000 ($183,000 for married couples filing jointly). This is the basic contribution limit, but it gradually decreases if your income falls between $116,000 and $131,000 ($183,000 to $193,000 for married couples).

There is a workaround, however: the Backdoor Roth IRA. With this strategy, you contribute to a traditional IRA and then convert it into a Roth IRA. Currently, there are no income limits for conversions, allowing you to fund a Roth this way. Although there are some common pitfalls with this approach, Morningstar outlines potential issues, it’s a perfectly legal way to fund a Roth IRA when your income exceeds the limits.

The Roth IRA is popular for good reason: it offers a range of fantastic benefits. That said, a Traditional IRA also has tax advantages, particularly the tax-deferred benefit. If you’re saving for a major purchase in the near future, the ability to avoid taxes could help you achieve that goal more quickly.

Regardless, the most important thing is that you’re saving for retirement in the first place. The Roth comes with several benefits, but ultimately, nothing beats the achievement of financial independence.

Image by Nick Criscuolo.