If you keep up with the news, you have probably read all about the proposed tax law changes that could come to fruition in the coming months.


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For example, the Biden administration just proposed nearly doubling the capital gains tax rate for the wealthy to a whopping 39.6% (and an even higher 56.7% in California when including their state taxes) — a move meant to collect more taxes from Americans who earn most of their money through investing instead of active work. Plus, we all know that Democrats, who currently control Congress, are itching to raise income tax rates on families who earn more than $400,000 per year.

While it remains to be seen which tax proposals will actually become law, it seems pretty clear that taxes will have to go up in the future to pay for not only our growing national debt, but also our current wave of spending. With that in mind, smart investors are always looking for ways to legally pay less in taxes now, or to set themselves up for lower taxes in the future.

Enter the Roth IRA, a type of retirement account that was established back in in 1997. The Roth IRA has been drawing renewed attention due to the growing evidence that tax rates have nowhere to go but up.

How Roth IRAs Work

In case you're unaware how this retirement account works, the Roth IRA lets eligible workers invest for retirement with after-tax dollars. Money in a Roth IRA is then able to grow tax-free until the contributor reaches retirement age, at which point they can begin taking distributions without paying any income taxes.

Eligible individuals can contribute up to $6,000 to a Roth IRA in 2021, although people who are ages 50 or older can contribute an additional $1,000 per year with what is known as a catch-up contribution.

That's a pretty low contribution limit when you compare the Roth IRA to more popular retirement accounts like the 401(k) or Solo 401(k), yet this account is meant to be used on top of other retirement accounts. In other words, you can have any other retirement account through work or self-employment but still contribute to a Roth IRA if you meet income requirements.

Why Are Roth IRAs So Popular?

According to Orange County, California financial advisor Christopher Struckhoff of Lionheart Capital Management, the popularity of Roth IRAs is all based on how this account treats taxes.

"Tax rates are at current historical lows, and there is no guarantee that they stay at these low rates," he says. With that in mind, locking in today's low rates could be a stellar deal.

This benefit will mostly come into play for people who expect to be in a higher tax bracket come retirement age. If you're currently in the 24% tax bracket and you expect to pay over 30% or 40% in federal taxes several decades from now, for example, paying those taxes upfront can help you save money. Not only that, but your money will enjoy tax-free growth until you're ready to begin taking distributions, and even during your retirement.

Greg McBride, who serves as Chief Financial Analyst at Bankrate , says another often overlooked benefit of the Roth is the fact this account lacks Required Minimum Distributions (RMDs). In other words, you aren't required to take distributions from this account once you reach a certain age.

"The lack of Required Minimum Distributions allows retirees more time to allow their Roth IRAs to grow until they truly need the money," he says. "In that sense, a Roth IRA is a form of longevity insurance.”

Financial advisor Jacob Rademacher of Fidelity’s eMoney Advisor also points out that Roth IRAs can be incredibly useful from a legacy or estate planning perspective. This is due to the fact your beneficiary does not have to pay taxes on distributions when they inherit your Roth IRA.

Rademacher also says this is not the case for a traditional IRA, so the net value of the asset is greater for those who inherit a Roth IRA.

Should You Contribute To A Roth IRA?

If you think the idea of tax-free income in retirement sounds good, you may want to consider opening a Roth IRA and getting started. Just keep in mind that income caps limit who can contribute to a Roth IRA account directly.

If you file taxes as a single person, your modified adjusted gross income (MAGI) must be below $140,000 to be able to contribute to a Roth IRA and under $125,000 to contribute the full amount. If you're married filing jointly, on other hand, your MAGI must be below $208,000 to contribute to a Roth IRA and under $198,000 to contribute the full amount.

Financial advisor Michael Shea says a Roth IRA can be helpful on its own, but also as part of a comprehensive portfolio with pre-tax, after-tax, and taxable retirement accounts. With this kind of set-up, you can assess your tax situation at retirement to determine the best way to distribute funds that save you the most money in taxes.

"This strategy makes your portfolio more dynamic in changes to the tax legislation," says Shea.

The Bottom Line

Pay taxes now or later, but you'll pay them one way or another. The Roth IRA lets you get taxes out of the way at today's rates, which could be immensely helpful if you wind up being in a considerably higher tax rate later in life.

Still, there are certainly situations where contributing to a Roth IRA won't make sense — or when Roth IRA contributions are only optimal once you take care of other aspects of your finances first. If you're curious whether a Roth IRA is right for you, consider turning to a fee-only financial advisor for help.

By Robert Farrington, Senior Contributor

© 2020 Forbes Media LLC. All Rights Reserved

This Forbes article was legally licensed through AdvisorStream.

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William L Curry, JD MBA AEP CLU ChFC
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