March 17, 2014

Stuart Ritter Stuart Ritter, CFP®, is a financial planner and vice president of T. Rowe Price Investment Services.

The potential for tax-free income and withdrawals from Roth IRAs make them a smart savings tool for most investors.

A Roth IRA is an individual retirement account that provides tax-deferred growth potential and the potential for tax-free withdrawals. The result: All of your contributions—and any growth they produce—can be withdrawn tax-free as long as you are age 59½ or older and have held the account for five years or more when you withdraw the assets. By comparison, contributions to a Traditional IRA, as well as their growth, are only tax-deferred. Once you retire, any withdrawals from a Traditional IRA generally are taxed as ordinary income.

More Spendable Income

Contributions to a Roth IRA don't qualify for a tax deduction. However, for most investors, contributing to a Roth IRA can help maximize spendable income in retirement, a feature that may outweigh the fact that contributions are not deductible. Tax-free withdrawals mean you're able to use all the funds you take out, not just a portion. In addition, you only need to take distributions from a Roth IRA if you need them. In a Traditional IRA, you must take required minimum distributions (RMDs) from your account starting April 1 of the year after you reach age 70½. RMDs are considered part of your adjustable gross income, which means they can affect your tax situation.

When a Roth IRA Makes Sense

Besides your income eligibility, two factors will help you decide whether a Roth IRA is appropriate: your expected tax rate in retirement and the amount of time before you'll withdraw from the account. If you think you'll be paying a higher tax rate in the future, a Roth IRA can be a good choice. Withdrawals from a Traditional IRA would be taxed at that potentially higher future rate, while any Roth IRA withdrawals could be tax-free.

If, like most investors, you expect to pay the same tax rate in retirement, a Roth IRA still makes sense in most cases. The longer you have until retirement, the more advantageous a Roth IRA's tax-free growth potential can be. A Roth IRA would not be a better choice if you know you will pay a substantially lower tax rate in retirement and you have a short time horizon before withdrawing those funds.

Tax Diversification

Roth IRAs also allow you to diversify your retirement income from a tax perspective. For example, say you're planning for a large, one-time expense in retirement. If you increase your withdrawals from a Traditional IRA to cover the cost, the added income could push you into a higher tax bracket. A Roth IRA, on the other hand, allows you to withdraw the extra funds tax-free.

Roth IRAs can be a powerful tool, providing both flexibility and more spendable income in retirement. Consider using one to help meet your retirement savings goals.