Roth IRAs are not a secret anymore since they first became available in 1998 as a way to use after-tax money to save for retirement. The biggest benefit is that as long as the Roth IRA account has been open for 5 years and withdrawals take place after age 59 ½, you never have to pay taxes on the earnings (contributions are always accessible without taxes). Tax-free earnings growth has a lot of appeal for younger generations and people not in their peak earning years who expect to be in a higher tax bracket during retirement.
But does putting retirement savings in a Roth IRA make sense for everyone? Like many financial planning questions the answer remains- it depends. Here a few of the reasons you might consider staying away from a Roth IRA:
You will be too tempted take out your contributions early. A wonderful feature of Roth IRAs is the ability to access your contributions at any time without taxes or penalties. Some people even may choose to include Roth IRA contributions as part of their emergency savings. But this ease of accessibility can be dangerous for people who may be easily tempted to withdraw these contributions prior to retirement for non-emergencies.
The human capital effect outweighs investment opportunity cost. If you are young, there is a pretty good chance that you will see both your earned income and your income tax rates increase significantly throughout your career. While this is part of the argument for investing in Roth accounts with their tax free growth of earnings, it is also a potential reason to avoid a Roth account if those contributions could be put to better use by increasing your greatest asset – human capital. If you are debating between contributing to a Roth or advancing your knowledge and earnings potential, it just may make more sense to focus on career development for the best return on your investment.
Tax rates may not go up. A common argument for Roth accounts is that income tax rates will likely increase in future years to address our nation’s growing debt problems. The reality is that although we are currently in a historically low income tax environment today, there is no guarantee where future tax rates may be headed. With global economic concerns and soaring national debt, my guess is we just may see higher tax rates in the next 20-30 years. But that’s really all we have to go by is guessing when it comes to future tax rates. And looking back to the congressional debate about the so-called fiscal cliff toward the end of last year, we really didn’t have a clue where our income tax rates would end up for this year until early January. Who knows what future Congresses could do? We could even see a national sales tax or a VAT that would be applied to all spending, whether it came from a Roth or not.
Your tax bracket may not be higher. Even if tax rates do increase across the board, your income in retirement may or may not be taxed at a higher rate than your income during your working years. You have to really examine your potential retirement income sources to estimate how your income will be taxed during retirement (and the rate at which it will be taxed). For example, Social Security is taxed at different levels depending on your income ranging from 0% to 85% taxable. Qualified dividends and long term capital gains from investments held in taxable brokerage accounts are subject to lower tax rates while interest from municipal bonds is federal tax-free.
You plan on living a frugal lifestyle in retirement. Retirement preparedness is at dangerously low levels and many people do not feel confident in their ability to replace 75-80% of their pre-retirement income. Why is it so important to try to replace about 75-80% of your income? This is the amount that many researchers and financial professionals recommend is needed on average by retirees to maintain their same comfortable standard of living during retirement. With so many people behind in their retirement savings, there is a strong likelihood that many retirees by choice or necessity will have to rely on less than the 80% income replacement rate. In that case, there’s a good chance they might retire in a lower tax bracket.
You plan on gifting retirement accounts to charity. Traditional IRAs are a much better option if you plan on making a charitable donation using IRA assets. Because Roth IRA distributions are federal income tax free as long as the account has been open for 5 years and beyond age 59 ½, there is no additional tax advantage of donating Roth account distributions. In contrast, you can avoid paying any tax on up to $100k of traditional IRA distributions each year by donating them to charity.
You are overwhelmed with investment choices. Does the thought of managing your own investments give you anxiety? Some people prefer taking a hands-on approach to managing their investments. Others prefer a hands-off approach and use professional money managers, asset allocation funds, and target date mutual funds to meet their investment goals. If you have low-cost investment options available through your retirement plan at work and you simply don’t want the hassle of managing your portfolio, then a pre-tax or Roth 401(k) may be a better option than an IRA.
As you can see, there are a lot of factors to consider when deciding whether to contribute to a Roth IRA. The good news is that if you’re just not quite sure, you can always put part of your retirement savings into a Roth account to give you some tax diversification. Even if you would have been better off putting that money in a 401(k) or traditional IRA, it’s much better than not having saved that money at all.