The most talked-about benefit of a Roth IRA is the investor’s ability to withdraw funds from this account without incurring income taxes. A key point of debate about funding a traditional IRA or a Roth IRA often centers on receiving a tax break immediately (traditional) versus enjoying it later in life (Roth).
One of the unique advantages of a Roth IRA may get overlooked in these discussions. Unlike a traditional IRA, a traditional 401(k), and a Roth 401(k), the Roth IRA is free from required minimum distributions (RMDs), or the minimum amount you must withdraw from your account each year (once you reach age 70½).
By avoiding the RMD, you can continue to grow wealth tax free well into your 70s, 80s, and beyond. That means your traditional investments can cover day-to-day living expenses in retirement while the Roth investments can accumulate extra wealth and allow you to spend more on your family in your later years—or even provide a cushion for end-of-life care.
The following scenarios illustrate how this Roth IRA feature could work in retirement.
Grow Wealth Tax Free
Let’s say Christopher is 73 years old, and the balance in his traditional IRA was $500,000 on Dec. 31, 2013.
At the beginning of 2014, he took an RMD of approximately $20,000, expecting to spend it on a new car, because he knew he had to take it from the IRA anyway. At the last minute, he changed his mind and decided to wait until later in the year when the new car models came out, so he invested the funds outside the IRA in a diversified but conservative portfolio with 50% in stocks and 50% in bonds.
During the year, he earned around $500 in dividends and also had about $1,500 in capital gains as the market went up. In September, the new car models were available, so he sold the investment and now he owes tax on the dividends, the capital gains, as well as the RMD.
Had his investment been in the Roth, Christopher would not have needed to take any RMD. He could have left the funds in the IRA all year, wouldn’t owe tax on the withdrawal for the car, and the gains and dividends would remain in the IRA to grow further tax free.
Keep Earning Without Triggering Tax Liabilities
Not only can you avoid taking distributions with a Roth IRA, but you can also earn money without complicating your tax life.
Consider another scenario in which Jessica, also 73 years old, has $500,000 in a Roth IRA as of Dec. 31 last year. She decided not to take money out of her Roth IRA this year.
Armed with excellent health and a sense of adventure, Jessica spent her summer working at a national park, where she earned a modest income. In addition, she received Social Security benefits. Because she was able to work to pay her living expenses without tapping into her Roth IRA, the investments in this account continued to grow.
If Jessica had held these retirement funds in a traditional IRA, she would have had to take an RMD, even if she didn’t ‘need’ the money. This distribution, added to the earnings from her seasonal job, could have increased her combined income so that she would owe taxes on her Social Security benefits. To generate the cash to pay these extra taxes, she may have had to withdraw additional funds from her IRA. So having her funds in a traditional IRA instead of a Roth would increase her taxable income and reduce the balance of her savings, further decreasing her ability to grow wealth.
The Roth IRA provides you with flexibility to manage your tax situation and continue to build wealth throughout your lifetime.
Whether your tax rate will be higher or lower in retirement is just one factor to ponder when determining what type of retirement account to fund. Tax laws concerning contribution caps, eligibility, and RMDs are constantly changing. But it will always be important to know how various types of accounts produce income streams—or if they don’t—and how that affects taxes and wealth.
More from Betterment:
- How to Do a Direct IRA Transfer
- IRA Calculator: Which Is the Right Type for Your Goals?
- Roth IRA Rules: Smart Ways to Avoid Taxes on a Conversion
This article is intended for educational purposes only. The information provided is educational in nature, and is not intended to be relied upon as financial or tax advice. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.