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One of the best ways to prepare financially for retirement is to take advantage of retirement accounts. They allow you to save and invest for retirement while also providing tax benefits — a win-win.

A 401(k) is the most popular retirement account and usually a person’s primary option. However, one account stands out from the rest because of its distinct tax benefits and flexibility: a Roth IRA.

Someone smiling and holding a piggy bank in hand.

Image source: Getty Images.

How Roth IRAs work

Unlike a 401(k) plan, a Roth IRA (or any IRA) isn’t tied to your employer. You must open an account on your own, like you would a brokerage or checking account. 

What separates Roth IRAs from traditional IRAs and 401(k)s is when you get your tax break. You contribute after-tax dollars and then receive tax-free withdrawals in retirement, as long as you’re 59 1/2 years old and have had your account for at least five years.

Any tax break is good, but the opportunity to have money grow and compound with no taxes on the back end is a tremendous advantage. 

Tax-free withdrawals in retirement are a gift from Uncle Sam

As an example of the value of tax-free withdrawals, suppose someone invests $540 monthly in a Roth IRA (adding up to just below the $6,500 annual contribution limit for people under 50) and averages 10% yearly returns.

Here’s how those investments would stack up based on how long you invest:

Years Invested Ending Value Capital Gains
10 $103,200 $38,400
15 $205,800 $108,600
20 $371,100 $241,500
25 $637,200 $475,200
30 $1.06 million $871,500

Source: Author calculations. Values rounded to the nearest hundred.

The capital gains portion is important because that’s what investors owe taxes on whenever they sell their investments. Any single filer making over $41,675 and any married couple filing jointly making over $83,350 would owe either 15% or 20% in capital gains taxes.

If those investments were made in a brokerage account, here’s roughly what would be owed:

Capital Gains Amount Owed At 15% Amount Owed At 20%
$38,400 $5,760 $7,680
$108,600 $16,290 $21,720
$241,500 $36,225 $48,300
$475,200 $71,280 $95,040
$871,500 $130,725 $174,300

Source: Author calculations.

In each scenario, making those investments in a Roth IRA saves you thousands of dollars in retirement. For some people, the amount saved could equal a year or more of retirement income.

The investment flexibility of a brokerage account

A 401(k) also has great tax benefits but limited investment options. Meanwhile, any investment available to your standard brokerage account is available to your Roth IRA too. Whether it’s an individual stock, industry-specific exchange-traded funds (ETFs), fixed-income investments, or sometimes even alternative assets, the number of options far exceeds that of most 401(k) accounts.

Your investment choices should reflect your financial goals and risk tolerance, so having more options gives you the flexibility you need to optimize your portfolio.

Prefer to be a passive, hands-off investor? That’s fine, too. You can choose a broad index like the S&P 500 and call it a day. What matters is that you can do what best fits you; you’re not at the mercy of the limited menu of your employer’s 401(k).

You may not always be eligible to contribute to a Roth IRA

One downside to a Roth IRA is the income limit to be eligible to contribute to one. Anyone can contribute to a 401(k) and traditional IRA (although it can affect deduction eligibility), but the income limit to be eligible to contribute to a Roth IRA is $153,000 if you’re single and $228,000 if you’re married and filing jointly.

The good news is that your investments can continue to grow and compound even after you’re no longer eligible to contribute. That’s why it’s beneficial to take advantage if you can. Even a one-time investment could grow close to 160% over 10 years, assuming 10% annual returns.

Who is a Roth IRA right for?

Despite its many benefits, a Roth IRA may not be the right choice for everyone. It usually comes down to your current tax bracket versus your projected tax bracket in retirement.

A Roth IRA makes sense if your current tax bracket is lower than your projected tax bracket. This allows you to pay taxes in the present and then enjoy tax-free withdrawals in the future when your tax bracket is higher.

On the other end, if your current tax bracket is higher than your projected tax bracket, it makes sense to go with a traditional IRA so you can get the tax break in the present and then pay taxes in the future when your tax bracket is lower.

These aren’t definitive rules, but they should be strongly considered.