There’s no denying that retirement accounts are one of the most effective ways to save and invest for retirement. They provide unique benefits, offer tax breaks, and have restrictions and penalties in place to deter people from dipping into the account before retirement.
In an ideal world, everyone could max out all their available retirement accounts. Unfortunately, this is unfeasible for most people, given the contribution limits on different retirement accounts. That said, if there is one retirement account to prioritize maxing out in 2024, it’s a Roth IRA.
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Roth IRAs have a unique tax break
A Roth IRA has a unique tax break compared to a 401(k) or traditional IRA. In a Roth IRA, you contribute and invest after-tax dollars, with the chance to take tax-free withdrawals in retirement. To be eligible for tax-free withdrawals, you must be 59 1/2 years old and have made your first Roth IRA contribution at least five years prior.
The tax breaks for a 401(k) or traditional IRA are on the front end, with the chance to lower your taxable income. However, the ability to take tax-free withdrawals with a Roth IRA can be more lucrative for retirees.
Generally, any capital gains you make on an investment will face capital gains taxes when you sell for profit. For most people, that means a 15% or 20% tax ($1,500 or $2,000 owed per $10,000 in capital gains). For people who consistently invest throughout their careers, using a Roth IRA can easily save thousands in taxes in retirement.
Below are the capital gains tax breaks for 2024:
| Filing Status | 0% Tax Rate | 15% Tax Rate | 20% Tax Rate |
|---|---|---|---|
|
Married, filing separately |
Source: IRS.
Even one year of maxing out a Roth IRA can pay off
Compared to a 401(k), IRAs have relatively low contribution limits. The most you can contribute to an IRA in 2024 — both Roth and traditional combined — is $7,000 ($8,000 if you’re 50 or older). Despite its relative smallness, even a $7,000 investment could go a long way over time, thanks to compound earnings.
A one-time $7,000 investment that averaged 10% annual returns over 10 years would grow to just over $18,000, meaning around $11,000 in capital gains. Instead of owing $1,650 (15%) or $2,200 (20%) in taxes, all the profits would be yours in a Roth IRA.
It’s easy to underestimate just how far a relatively low investment could go, but time is a powerful force in investing, especially with consistency. If you invested $7,000 annually over 10 years, averaging 10% returns, you’d have close to $41,500 capital gains. That could be $6,225 or $8,300 saved in taxes.
Benefits beyond the tax break
Tax break aside, a Roth IRA is great because of its flexibility. To begin, it operates similarly to standard brokerage accounts because you can invest in virtually any stock or exchange-traded fund (ETF) you want. Whether it’s The Next Big Thing growth stock or an ETF specific to an industry you’re interested in, you can invest in it. This differs from a 401(k), which provides investment options.
Roth IRAs also offer more lenient withdrawal rules. You can withdraw contributions — but not earnings — from a Roth IRA at any time without facing the typical 10% early withdrawal fee. The goal should be to leave your money in any retirement account until retirement, but sometimes, life throws a curveball. Having the flexibility to access your funds can provide a lifeline.
You can also take penalty-free early withdrawals from a Roth IRA for various life events. For instance, first-time homebuyers can withdraw up to $10,000 to put toward the home; withdrawals can be made for qualified education expenses, like tuition; and you can use funds to pay for health insurance premiums while unemployed. A 401(k) doesn’t offer any of those.
Take advantage while you can
A major con of a Roth IRA is its income limit ($161,000 if you’re single and $240,000 if you’re married and filing jointly). If you’re under the limit, the long-term tax benefits often make it worth taking advantage of a Roth IRA. You might not always be eligible, and any bit now can pay off later.
For people with a 401(k), I recommend contributing enough to get the most from your employer match and then focusing on maxing out a Roth IRA. It can be the best of both worlds.
