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  • 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 The result: All of your contributions—and any growth they produce—can be withdrawn tax-free as long as you are age 59½ or older and have held the account for five years or more when you withdraw the assets.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.

    Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.