8 Top Features of Roth Accounts
Roth accounts are one of my favorite financial tools. The value of tax-free wealth they can produce is difficult to overstate.
The very existence of Roth type tax-advantaged investing opens the door to all sorts of strategies for growing and preserving your money.
Here are the 8 best features they have to offer (IMHO).
1) Saying Goodbye to Uncle Sam
It is often said that death and taxes are inevitable, but in the case of a Roth account you can at least get the taxes over with early, then enjoy your money all to yourself after.
That’s because earnings and withdrawals from Roth accounts are completely tax-free.
Besides receiving a free step up in basis for your heirs after you die, HSAs are really the only other option I know of that moves the tax impact to the beginning of your investment, giving you the freedom to do what you want thereafter. And that’s only in the case of qualified medical expenses.
Roth’s are unique in the way they excuse the government from your portfolio.
If you’re one of those who is concerned about Uncle Sam changing the rules for Roth accounts, I can understand your concern, but I don’t think you have anything to fear.
We wrote a post and recorded a separate video to address this which I recommend that you check out if you’re worried the government might come after your Roth one day.
2) Tax Arbitrage
My 2nd favorite aspect of Roth Accounts is the ability they give us to engage in tax arbitrage.
All this means is that having the option to tax a tax deduction now (in a traditional account) or to pay it now (in a Roth account) allows you to pay taxes when they’re lower for you.
For example, when I first started contributing to a Roth IRA my income was low. I don’t remember what bracket I was in, but it was as low or lower than I’ll ever see again.
By paying tax at a lower bracket when I made my Roth contribution, I get to avoid paying a higher tax when I make withdrawals in retirement.
This could save me anywhere from 8% up to more than 20% on taxes when I make my withdrawals. That opportunity wouldn’t exist if there weren’t any Roth options.
3) No Required Minimum Distributions (RMDs)
When you reach age 72, 73, or 75 (depending on when you were born) the government will require you to begin removing money from your tax-deferred or traditional retirement accounts.
This is going to force you to realize income on this money and then be taxed for it.
If you need that money to live on, then this isn’t a problem at all.
However, if you don’t need the money then it creates an unwanted tax liability. It also means you aren’t really in full control of your retirement savings.
Well, if your money is in a Roth IRA or 401(k) there are no RMDs, so this is not a problem for you.
4) Roth Conversions
Next, Roth accounts give us the opportunity to convert money that is in traditional accounts in years where our income is in lower brackets.
One key reason you might want to do this is if you’re facing significant required minimum distributions in your 70s that would push you into higher and more costly tax brackets.
By having the option to convert to Roth, you can potentially avoid higher taxes and gain a higher degree of control over your income situation when you reach RMD age.
This is definitely a financial planning option to keep in mind in the years after you retire, but before you are forced to pull out those RMDs.
We also have another video and post about Roth Conversions which you can check out for more details.
5) Backdoor Roth IRAs
I guess we can credit the IRS with this one since it exists as a bit of an accident.
Roth IRAs have maximum income restrictions that prevent individuals with high incomes from contributing directly to a Roth IRA.
We’ve got those limits on the screen now.
The good news is you can still contribute to an IRA on an after-tax basis, then convert the contribution to a Roth IRA.
So, there’s an extra step to a Roth IRA contribution if you have high income, but at least there is an option for funding a Roth IRA if you wish.
This is a perfectly legal loophole to take advantage of and millions of people have been doing it for well over a decade now.
If you decide to try a backdoor Roth IRA, be sure to keep the pro rata rule in mind. It basically requires you to pay income tax for your conversions on a pro rata basis for all of your IRAs.
So, if you have a traditional IRA, you might have to pay income tax on a portion of that balance in order to use the Backdoor Roth strategy.
We’ve got more details on that in yet another post and video.
6) Legacy Planning
I’ve said many times that Roth accounts are the best way to receive an inheritance, and no one has disputed it yet, so I’m going to keep preaching it.
Most assets that are left to your heirs receive a free step up in basis, meaning they won’t have any immediate tax liability connected to the value of the assets they inherit when you die.
Traditional/Tax-deferred retirement counts are an exception. All withdrawals from tax-deferred retirement accounts, even as an inheritance, are taxed as income.
Roth’s, on the other hand, also enjoy tax-free treatment even after they’re inherited, but they also enjoy another wonderful feature.
When you inherit other assets your step up in basis means you won’t owe any tax on capital gains that may have been realized during your benefactor’s lifetime, but any capital gains after they pass will be taxable to you once you sell the assets.
However, Roth dollars remain tax-free as long as they sit in the account that you’ve inherited. That means any earnings or growth that’s realized remains tax-free, even years after the benefactor’s death.
Now, it would be really nice if you could just leave inherited Roth accounts alone to grow indefinitely, but you’ll have only 10 years to let the account grow if you’re a named beneficiary.
7) Help Avoid Medicare Surtax
Because Roth withdrawals don’t count toward your modified adjusted gross income (MAGI), they give you a source of income in retirement that won’t cause your surtax to increase.
The Medicare surtax applies to individuals to pay an additional 3.8% if their income reaches certain thresholds.
By pulling income from a Roth instead of a tax-deferred or other investment account, you can potentially avoid this tax altogether.
8) Extra Emergency Funds
Last on my list is the ability to remove Roth contributions at any time, tax and penalty free.
The reason you’re allowed to do this is because Roth contributions are already taxed going in.
If the government penalized you for removing money you’ve already been taxed on it would make it more difficult to encourage taxpayers to participate in a Roth plan.
So, if you’re ever in a pinch and need some cash fast, your Roth could potentially bail you out.
With that said, this is the last item on my list because I would never recommend raiding the Roth unless you’re out of better options.
That’s because once Roth contributions are removed, they can never be put back. This means by removing contributions you’re forfeiting all the interest you could have earned for years to come.
Instead of raiding your Roth, just build up a solid emergency fund like we recommend in the Next Dollar Roadmap.
That way you’ll have a place to go for cash without wrecking your Roth.
Conclusion
There are other Roth features that we didn’t cover in this list.
Namely, the ability to use a Roth to save for college or for your first house. We’d lump them in at the bottom of the list with emergency funds if we put them anywhere because they require the removal of money from the Roth for something other than retirement.
There are better ways to save for emergencies, college, or a house.
Overall though, there is no shortage to the number of options Roth accounts can give you for building wealth.
