Think a Roth IRA Is Your Best Bet for Retirement Savings? Here's Why It Could Backfire.
Key Points
Roth IRAs offer benefits like tax-free investment gains and withdrawals.
They also don't force you to take required minimum distributions.
The flexibility Roth IRAs give you could be your downfall.
- The $23,760 Social Security bonus most retirees completely overlook ›
Roth IRAs (individual retirement accounts) are often praised as one of the best retirement savings tools available. And the appeal is easy to understand.
With a Roth IRA, your money gets to grow tax-free, withdrawals in retirement are tax-free, and there are no required minimum distributions to worry about. It's that flexibility that makes Roth IRAs so attractive.
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But the flexibility that comes with a Roth IRA could end up being a bad thing. And if you're not careful, saving for retirement in a Roth IRA could end up being a huge mistake.
The temptation of early access
When you take an early withdrawal from a traditional IRA (meaning, prior to age 59 and 1/2), you generally risk a 10% penalty unless you qualify for an exception. But Roth IRAs give you more options for tapping your savings early.
Since there's no tax break on the money you put into your account, a Roth IRA lets you access your principal contributions penalty-free at any age. Need $12,000 to fix your roof? If you have a $40,000 Roth IRA balance but only $15,000 of that is gains, you can withdraw up to $25,000 without a penalty since that represents money you put in.
You might think that flexibility is a good thing. In the context of building a retirement nest egg, it's actually not.
If you keep tapping your Roth IRA when a need for money arises, you risk ending up with a big shortfall by the time your senior years arrive. And remember, every dollar you withdraw from a Roth IRA ahead of retirement is a dollar you can't invest.
Remember how Roth IRAs give you tax-free gains? That's a lot of money to give up by taking early withdrawals. A $12,000 distribution at age 35 to fix your roof could mean giving up close to $109,000 in tax-free gains by age 65, assuming your portfolio gives you an 8% yearly return, which is below the stock market's average.
If you're going to use a Roth IRA, do this
Saving for retirement in a Roth IRA isn't automatically a bad idea, since these accounts offer a host of benefits. But if you're going to choose a Roth IRA, make absolutely sure you have a separate emergency fund for near-term needs.
If you maintain a separate cash emergency fund, you'll be able to tap that account when your car needs work or a home repair situation arises. You may be a lot less tempted to raid your retirement savings and risk a shortfall later on.
Roth IRAs are often praised for their flexibility, but that could become a disadvantage in the context of retirement savings. To get the most out of a Roth IRA, consider it a long-term savings tool first and keep an emergency fund in a separate account so you don't accidentally whittle down your nest egg before your retirement begins.
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