The following is a guest post by DJ Whiteside, who is the author of the book “Save BETTER!” and writer for My Money Design, a blog where he talks about saving his way to an early retirement and financial freedom. If you’d like to submit a guest post to Money Q&A, be sure to check out the site’s guest posting guidelines.
I know you’ve probably read this before: The financial media LOVES to recommend Roth IRA’s.
Make no mistake: Saving your money in a Roth IRA is a smart move. Pay your taxes now – enjoy tax-free income when you retire!
BUT is it always the smart move for you? In some situations, you might actually be better off going with a traditional IRA instead.
When is Investing In a Roth IRA Right?
Here are the major factors that can help you to understand when a Roth IRA might be a better fit for you over a traditional.
If You Plan to Retire With More
Do you know how much money you’re going to need when you retire?
This is the number one question that you need to ask yourself in order to pick which road you’d like to go down: The traditional-style plan or the Roth.
Generally speaking, if you plan to live on less money than you’re earning right now, then the traditional style plan will work out better. This is because if things are similar to how they are now, you’ll be in a lower tax bracket and likely pay less in taxes.
On the other hand, if you’re going to be fortunate enough to enjoy more money than you’re earning right now, then you’ll be in a higher tax bracket and would owe more in taxes. Therefore, the Roth would be your better bet.
If You Earn Too Much
How much you earn can affect whether or not you can contribute to a traditional or Roth IRA.
If you earn more than $99,000 AND participate in another retirement plan, like a 401(k), then according to the 2017 IRS rules you cannot deduct your traditional IRA contribution.
On the other hand, you can fully contribute to a Roth IRA as long as your adjusted gross income (AGI) is not over $186,000.
Therefore, if you earn somewhere between $99,000 and $186,000, then go for the Roth.
If you Plan to Contribute the Max
On the surface, you may think that both IRA types have the same contribution limit of $5,500 per year. But take a closer look and you will see that this is not true.
When you contribute $5,500 to a traditional IRA, you’re simply setting aside “$5,500” and no taxes. Then, as we already know, you will have to pay taxes on your withdrawals once you retire.
Keeping this mind, now switch over to the Roth IRA. A contribution of $5,500 isn’t really “$5,500”. It’s actually $5,500 PLUS the taxes of whatever tax bracket you’re in. If that’s 25%, then you’re really setting aside $5,500 plus $1,833 in taxes for an effective total of $7,333.
So even though it may not “feel” like it, you’re effectively saving more of your money each year with the Roth.
If There’s An Emergency
You may not know this, but you can actually withdraw the “contribution” portion of your Roth IRA any time you wish. This is because you’ve already paid taxes on these contributions to your savings, and so from the IRS’s perspective they’ve already got what they needed from it.
This is good news if you’re ever in a “true” emergency and really your funds quickly. I’d much rather make a small withdrawal from my Roth IRA than put that emergency expense on my credit card and rack up debt at a 30% interest. (I stress the word “true” because you only want to compromise your retirement savings as a last resort. Your first resort should be to build up an emergency fund to handle these sorts of situations.)
With a traditional IRA, you do not have this option. At best, you can take a short-term 60-day loan that is interest-free.
If You’d Like to Retire Early
If you plan to retire early (like we do), then the Roth is going to be your better bet.
Why? Withdrawing those penalty-free, tax-free Roth IRA contributions are going to be very useful in bridging those early years when you can’t access your retirement savings without getting a 10% penalty (generally before age 59-1/2).
With a traditional IRA, early withdrawals are not as straight-forward. You would need to use a more advanced technique such as a 72t or Backdoor Roth IRA conversion.
If You’d Like to Skip RMDs
Though you may not be thinking about it now, when you turn age 70-1/2, the IRS will force you to make withdrawals from your traditional retirement savings accounts (called “required minimum distributions” or RMD’s). If you don’t, there will be a hefty 50% penalty to pay! Ouch!
Why do they do this? Because the IRS doesn’t want to wait forever to collect on the taxes you’ve been deferring this whole time.
With the Roth IRA, again – because you’ve already paid your taxes, RMD’s are not required. This means you can take out as much or as little without any government intervention.
If You’d Like to Pass It On
Though it’s not fun to think about, if you’d like to pass on your savings to someone else after death with the least amount of a headache, then the Roth is the better way to go. Both gifts will require your beneficiaries to withdraw a minimum amount each year. However, with the Roth, those distributions get the extra bonus of being tax-free.
Author bio: DJ is the author of the book “Save BETTER!” and writer for My Money Design, a blog where he talks about saving his way to an early retirement and financial freedom. Connect with him via Facebook and Twitter.
Thanks again Hank for allowing me the opportunity to guest post on your site. I think Roth IRA’s are a pretty great thing to have available, and I’m glad they exist. But when it comes to what’s really “the best thing” for your savings, most people would be doing themselves a wonderful service to look beyond generic media headlines and really consider if a Roth is right for their situation.