Many people are quick to tout the Roth IRA as the best retirement savings tool out there. And it’s easy to see why.
With a Roth IRA, your contributions are made after taxes. But you get the benefit of tax-free gains in your account and tax-free withdrawals during retirement.
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Roth IRAs also don’t force savers to take required minimum distributions. That gives you more flexibility with your savings.
Plus, because Roth IRA withdrawals aren’t treated as taxable income, distributions won’t increase your likelihood of having to pay taxes on your Social Security benefits. You may be subject to those taxes for a different reason. But Roth IRA withdrawals aren’t included in the formula that determines that.
Similarly, withdrawing from a Roth IRA instead of a traditional retirement account could lower your chances of getting stuck with surcharges on the Medicare premiums known as IRMAAs, or income-related monthly adjustment amounts. IRMAAs could add hundreds of dollars a month to the cost of Medicare Part B alone, so avoiding them is a very good thing.
Despite these major benefits, it’s not a given that a Roth IRA is the best retirement savings tool for you. Here are two reasons why.
1. You may need the tax savings more during your working years
With a Roth IRA, you pay taxes now instead of later. That makes sense if you expect to be in a higher tax bracket during retirement than you’re in now. But that may not end up being the case.
If you have a great career, your income may be substantial enough during your working years that you’re in a higher tax bracket in your 30s, 40s, and 50s than you are in your 60s and beyond. And if that’s the case, choosing a Roth IRA could mean voluntarily paying a higher tax rate on your money than you would down the line.
For example, say your salary pushes you into the 32% tax bracket today. You may end up in the 22% bracket in retirement. And if that happens, funding a Roth IRA locks you into paying the IRS more.
Of course, the tricky thing is that we don’t know where tax brackets are headed. But if you earn a high salary, a Roth IRA may not be for you.
2. You may end up with a savings shortfall if you aren’t disciplined
Because Roth IRA contributions are made with after-tax dollars, there’s no penalty for taking early distributions as long as you’re touching the principal portion of your account only, not the gains portion. But that flexibility could end up being a problem.
If you treat your Roth IRA as your emergency fund and keep dipping in to cover unplanned bills, you might whittle down your balance over time. That could leave you with a big savings shortfall once retirement rolls around.
And remember, when you take an early Roth IRA withdrawal, you lose out on the opportunity to grow that money tax-free. A $9,000 withdrawal at age 40 could cost you close to $62,000 in retirement income if you start tapping your account at 65 and your investments generate an 8% annual return, which is a bit below the stock market’s average.
Now, if you’re very disciplined and pledge to maintain a separate cash emergency fund, this may not end up being an issue. But you need to be honest with yourself.
If you think you’ll be tempted — repeatedly — to tap your retirement savings early, then you may be better off with a traditional IRA, where you’ll face a 10% penalty for taking money out before age 59 1/2. That penalty may be enough of a deterrent for you to leave your savings alone.
Roth IRAs are great. But it’s not a given that saving in one makes sense. Think about the drawbacks of using a Roth IRA to house your nest egg, and take your earnings and discipline into account when making a decision.
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