Over the last few blog posts, we’ve discussed ways to save money in order to achieve financial independence. The next logical question is where those savings should go. After maxing the match in your employer’s retirement plan and paying off any high interest rate debt, I would suggest contributing as much as you can to a Roth IRA. That was the first retirement account I opened early in my career, and it’s one of the first accounts I put money in at the beginning of each year.
First, for those who don’t know what a Roth IRA is, here’s the skinny. It’s an individual retirement account that you can open at almost any bank, credit union, brokerage firm, or mutual fund company, and invest it in almost anything you want. You can contribute up to $5k of earned income each year to an IRA, or up to $6k if you’re over the age of 50. In order for it to be a Roth IRA, your adjusted gross income must be below certain thresholds (but if you’re ineligible, you can simply contribute to a traditional IRA and then immediately convert it into a Roth since the income limit was eliminated for Roth conversions). The account is sheltered from taxes until you make a withdrawal. The earnings can be withdrawn tax-free as long as the account has been open for at least 5 years, and you’re over the age of 59 ½, but otherwise the earnings are subject to taxes plus possibly a 10% penalty when they’re withdrawn.
So why do I love this account so much? Let me count the ways…
1) Investment flexibility: Unless your employer’s retirement plan offers a brokerage option, you likely have a very limited number of mutual funds to choose from. If you’re picky like me, you’ll appreciate the much wider selection of investments available to you in an IRA.
2) Access to your money in the short run: This is such a little known rule that I once won a bet with another financial planner over it. Unlike with a 401(k) or a traditional IRA, you have relatively easy and painless access to most of your money because you can withdraw the sum of your contributions at any time, for any purpose without tax or penalty. That means it can do double duty by being used to help build your emergency savings too. The only hitch is that if you withdraw any earnings early, you’ll have to pay taxes and possibly the 10% penalty on them, but all the contributions come out first. Of course, this could make it tempting to use it for things that aren’t quite “emergencies.” Hopefully, the fact that you have to fill out a very serious looking form each time you make a withdrawal, will help discourage you from raiding it to buy the next iPhone.
3) More tax benefits in the long run: It may feel good at tax time to get a tax deduction now, but assuming tax rates stay the same, you’re better off with $5k in a Roth account than in a pre-tax account over the long run. That’s because you’ll eventually have to pay taxes on the pre-tax account. The counter-argument is that you could invest the tax savings from the pre-tax contribution, but those savings would also be taxable. When you do the math, the Roth still ends up ahead after taxes. The longer the money is invested, the bigger that advantage is, so it’s particularly beneficial for young people.
4) Protection from Washington: What if tax rates don’t stay the same? Considering that income tax rates are currently near historic lows, they’re probably more likely to go up than down. In fact, rates are already scheduled to increase in 2013 and may continue to rise to pay for our growing national debt and entitlement spending. If that’s the case, you’re better off paying taxes now at current rates than at what could be much higher rates when you retire. Under current tax laws, less taxable income in retirement would also result in less of your Social Security benefits being taxable.
5) More money for your heirs: There’s also an advantage if you don’t need to spend the money in retirement. With a pre-tax account, you’ll have to start taking required minimum distributions when you turn age 70 ½. With a Roth IRA, you can leave that money to continue growing tax-free for as long as you like, and pass on the larger amount to your heirs. (This honestly didn’t really factor into my decision, but I suppose someone may benefit from it someday. I also wanted a 5th point.)
Does this mean no one should contribute to a pre-tax account first? Not necessarily. If you’re relatively close to retirement and it looks like you’ll be in a lower tax bracket when you retire, you may be better off putting that money into your pre-tax 401(k). But for the rest of us, the Roth IRA could be a useful tool in our journey towards financial independence.