Everyone says I need a Roth IRA. Do I really?
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If there is one thing that personal finance gurus all seem to agree on, it is this: You should have a Roth IRA account.
Alongside budgeting and having an emergency cash reserve, it has assumed its place as bread-and-butter advice. And why shouldn't it?
What could be more attractive than being able to salt away thousands of dollars each year, have that money grow over decades free of tax, and then withdraw both what you contributed and what you earned in dividends with no tax liability at all?
What could possibly be more delicious?
But, of course, one size never truly fits all. The near-universal recommendation to open a Roth IRA account ASAP is no exception to that rule.
First things first…
Do you have a cash reserve? According to a 2021 survey, 25% of American households reported having no emergency savings at all.
As much as you may want to jump straight to investing, which I freely admit is far sexier than a savings account, a Roth IRA (or any investment account) is not the place for your emergency fund.
Firstly, there is usually a steep penalty (10%) for withdrawing earnings from a Roth IRA before you are 59 ½ years old.
(For more details, see this page on the IRS website: Topic No. 557 Additional Tax on Early Distributions From Traditional and Roth IRAs.)
But more broadly, the whole point of investing (instead of saving) is to assume risk to earn a higher return.
In the long run, this can work out just fine.
In the short run, however, losses will inevitably occur. You do not want to be in a position of having to sell shares in your account, locking in losses, just to pay for a new set of tires.
Do you have access to a 401(k)?
If you have crossed building a cash reserve off your to-do list, and are ready to invest for the long term, next consider your workplace retirement plan if you have one.
Particularly whether you're contributing up to the maximum allowable annual limit ($22,500 in 2023 and an additional $7,500 for those aged 50 or older).
There is truly only one killer app for retirement saving, and that is the paycheck deduction.
It is the fundamental difference between saving for retirement through your workplace plan (your 401(k), 403(b), or similar) and using an IRA.
The paycheck deduction is superior because you never experience, even momentarily, having the money available to spend. Instead, you internalize the deduction in your thinking (and budgeting), just as you do taxes withheld.
Better still, some companies allow you to set up an automatic annual increase in the amount of your paycheck that's invested, gently nudging your savings rate up over time.
Even putting in place an automatic transfer from your checking account to an IRA is the second-best option.
It's simply too easy to turn it off when things feel “pinchy.” You will almost surely find multiple reasons to not increase your contribution regularly as other priorities crowd in.
Diverting a portion of your overall retirement investing to a vehicle outside of your workplace account could, if you are not diligent, result in a lower level of savings.
And don't forget, the contribution limit for a Roth IRA is far lower than that of a 401(k). In 2023, the maximum annual contribution is $6,500, or $7,500, if you are at least 50 years old.
Should you have a Roth IRA plus a 401(k)?
With all that said, reasons do exist that may lead you to choose a Roth IRA even if you are not fully utilizing your 401(k), contributing to the maximum annual limit. (Of course, you should always contribute at least what is necessary for an employer match if offered.)
1. Tax diversification.
In the olden days, workplace retirement plans came in only one flavor — traditional.
Contributions are deducted from your paycheck before taxes, lowering your tax liability immediately. On withdrawal in retirement, the total amount of your distribution is taxed as ordinary income.
However, we have come a long way, and many employers are now offering a Roth 401(k) option. Just like the Roth IRA, contributions are made from post-tax income, and distributions in retirement are entirely tax-free.
But not all employers offer a Roth 401(k).
If you believe that you will benefit from having tax-free income in retirement (more so than a lower taxable income today) and a Roth 401(k) is not available to you, then a Roth IRA is a valuable way to diversify the tax treatment of your retirement savings.
2. Early withdrawal flexibility.
I don't want you to make an early withdrawal from your retirement account, and you probably don't want to either.
Yet life happens, and when push comes to shove, the Roth IRA does offer more flexibility than a 401(k).
To start, you can withdraw your contributions (not earnings!) at any time without penalty. And if the Roth IRA account is open for at least five years, you can withdraw earnings without penalty or taxes to help with your house down payment.
(It is also possible to make a penalty-free, but not tax-free, early withdrawal for significant medical expenses or higher education costs.)
3. Better investment options.
As workplace retirement plans have matured, investment options have improved, with most offering a suite of attractive, low-fee mutual funds and ETFs.
Nevertheless, dud workplace plans still do exist, stuffed with high-fee investment choices.
And increasingly, investors want the option to select funds that align with their ESG (environmental, social, governance) goals.
In this case, it may make sense to divert a portion of your retirement nest egg to a Roth IRA at an institution that offers investment options that are more to your taste.
In short, the question to ask yourself if you favor a Roth IRA over your workplace retirement plan is, “What am I looking to get from a Roth IRA that I cannot achieve with my 401(k)?”
If you cannot articulate the value-add of the Roth IRA as it relates to your financial goals, then it may be superfluous for you.
- IRA vs. 401(k): How they differ and where to invest 1st
- Should You Open an IRA at Your Bank?
- Spousal IRA: What is it, and can I benefit from one?
Is your 401(k) enough?
Of course, if your goal is to maximize your tax-advantaged retirement savings beyond the maximum annual 401(k) limits, then a Roth IRA may be an excellent choice.
But beware! The households most able to afford this level of super savings are also likely those who cannot contribute to a Roth IRA due to income limits.
For 2023, the ability to use a Roth IRA phases out when your income exceeds $138,000 for a single tax filer ($218,000 if married filing jointly) and is entirely unavailable if your income exceeds $153,000 ($228,000 for married filing jointly). (For more details, see this page on the IRS website: Amount of Roth IRA Contributions You Can Make For 2023.)
The popularity of the Roth IRA is undeniable; according to the Investment Company Institute, in 2021, 21% of US households had a Roth IRA account.
Should you join the crowd?
Perhaps…but as always, first take a beat to consider if the conventional wisdom fits your unique circumstances. Remember, personal finance is personal.
Next: Three Tips for Staying Positive About Your Financial Future
Article written by Lisa Whitley, AFC®, CRPC®.
Lisa enjoys having money conversations every day with people from all backgrounds. After a long career in international development, she brings a cross-cultural dynamic to her current work to help individuals and families achieve financial wellness.