The Tax Reform Act of 1986 greatly simplified the once-byzantine United States Tax Code, but among its casualties was the individual retirement account, or IRA. No longer could investors receive highly attractive tax deductions by stowing their income in their IRAs, which discouraged prudent retirement savings for many Americans. But in 1997, Senator William Roth (R-DE) pushed for an alternative to the traditional IRA that inverted the tax burdens. By devising an IRA that taxed modest contributions up-front but paid out tax-free, Congress could concurrently reinstate the traditional IRA with its deductible contributions and taxed income. Now, the Roth IRA allows middle-class investors to enjoy retirement without substantial tax burdens. Here are some more of the top benefits of the Roth IRA.
One of the major drawbacks of the traditional IRA is the penalty that accompanies an early withdrawal. Though the CARES Act has temporarily waived such penalties in the wake of COVID-19, IRA investors felt the sting of early withdrawals when they treated their dedicated retirement fund as a rainy-day fund. Because the IRS has already taxed Roth contributions, investors can draw upon their Roth before its maturation without penalty, provided that the withdrawal comes only from the taxed contribution and not the money said contribution has earned in the account.
Opportunity for Conversion
The allure of tax-free retirement income can lead investors to reconsider their retirement plan, and thanks to the Roth conversion, that change is possible. Middle-class investors stand to benefit the most from Roth conversion in paying taxes ahead of retirement. However, higher-income investors can find a loophole with what is known as a “backdoor Roth conversion,” which circumvents the contribution limits on Roth IRAs.
Pay Out When You Want
After an investor reaches the age of 70, the IRS expects the IRA to start doing the work of paying out the money it has accrued so that they can tax it. These annual payouts are known as required minimum distributions. However, the Roth IRA, with its pre-taxed contributions, are not subject to required minimum distributions, so the Roth can distribute as little as you want if you’re not ready to withdraw yet. In fact, if you come to feel you’re ahead of schedule, a Roth need not distribute at all. Being able to not only save for retirement but also build an inheritance is one of the top benefits of the Roth IRA.
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