When it comes to retirement accounts, the finance industry doesn’t make it easy on you. Not only are the names of the different accounts painfully uncreative and frustratingly similar sounding — 401(k), 403(b), traditional IRA, Roth IRA, etc. — understanding and weighing the pros and cons of each type are enough to make your head spin.
There is one retirement account, however, with benefits so compelling that every investor should have one: the Roth IRA.
Before diving into the many advantages of a Roth IRA, let me first say I am not advocating you replace any other retirement account you may already have with one. For example, having both a 401(k) and a Roth IRA is a great way to set yourself up for a comfortable retirement.
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Advantage No. 1: Tax-free growth
By far, the most exciting advantage of a Roth IRA is the fact your investments grow 100% tax free. This perk is mind-boggling.
Roth IRAs came into existence when the Clinton administration signed the Taxpayer Relief Act of 1997, which was designed to drastically cut taxes for the middle and lower classes.
Since the money you contribute has already been taxed — as opposed to 401(k)s, which are pre-tax — you will never pay taxes on withdrawals from your Roth IRA, assuming you are at least 59 1/2 years of age and have owned the account for a minimum of five years.
Because of how advantageous this is, there is an annual contribution cap of $6,000.
But let’s just say for a minute you invested $6,000 in Microsoft (NASDAQ: MSFT) 30 years ago and held until today. The initial investment would now be worth over $600,000, and you would pay zero taxes on those gains when you withdraw. You’d have to pay over $100,000 in long-term capital gains taxes if that same investment was made in a 401(k) or self-directed brokerage account.
Now that’s what I call a perk.
That said, there are income limitations to contributing to Roth IRA accounts. High earners (over $144,000 for single filers and $214,000 for married couples in 2022) are inligible, but there is a work-around known as a backdoor Roth IRA.
Advantage No. 2: Much easier to withdraw early
One of the frustrating aspects of a 401(k) and other pre-tax accounts is how cumbersome it is to get early access to the funds in case of an an There’s paperwork, early withdrawal penalties, and then you’ll still need to pay the taxes on the money since the contributions went in pre-tax.
With a Roth IRA, you can pull out your contributions anytime, no questions asked (note: You cannot pull out any gains on your contributions until age 59 1/2).
While you should avoid early withdrawals from any retirement fund, the ease of access for Roth IRAs can let you breathe easier in emergency situations.
Advantage No. 3: No required distributions
Most retirement accounts require you to take minimum withdrawals at a certain age but not the Roth IRA.
This is big if you’re planning to keep working well into your 60s or even 70s. This advantage allows you to leave your money invested, grow tax free, giving you the flexibility to decide when you need to access the funds.
When you look at a compounding chart, you’ll realize how significant this benefit really is:
The chart above represents the total value of a Roth IRA account after 40 years versus the contributions made (assuming a 10% annual return and a $6,000 max annual contribution).
The first thing you should notice is the account value after 40 years is more than 10x the total contributions. But more importantly, the last five years of compounding are responsible for nearly doubling the account.
This really highlights the importance of leaving your money invested for as long as possible. And in the case of a Roth IRA, there’s nothing stopping you from doing just that.
Conclusion: Don’t sleep on the Roth IRA
Retirement accounts are not the sexiest investing topic, but the decisions you make around your retirement savings can have million-dollar implications (as seen in the chart above).
Although limited by the $6,000 max annual contribution, the advantages of a Roth IRA are simply too good to pass on. Whether you have a retirement account already or not, any investor that is serious about saving should be contributing annually to a Roth IRA.
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Mark Blank has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Microsoft. The Motley Fool has a disclosure policy.