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Finance and retirement planning experts are usually quick to recommend that one set money aside in a Roth account. And it looks like the vast majority of Americans agree with them.
A new survey hosted by Derek Sall, a personal finance expert and the founder of LifeAndMyFinances, found that 92% of Americans think they should be investing in a Roth IRA. Sall wasn’t surprised by just how many people are of the belief that Roths are a financial must-have.
“I estimated that 95% of people would say they should invest in a Roth — I wasn’t too far off!” Sall told GOBankingRates. “But why? Why did I think the percentage would be so high? Simple. It’s what I’ve heard all my life — from every smart investor, from every influencer. Even Dave Ramsey himself tells his millions of listeners to invest in a Roth. ‘It’s tax-free growth,’ they say. ‘You’ll have tax-free money in retirement,’ is another common one, [and] ‘taxes will likely go up in the future, so it’s smart to invest in a Roth now.'”
It all sounds so wise and the insight comes from wise people in the realm of personal finance. But in Sall’s opinion, this is horrible advice. Speaking to his own personal experience, he estimated a $400,000 loss of retirement income by having invested in a Roth IRA versus a traditional 401(k). What exactly did he discover?
The Tax Rate You Have Now Likely Won’t Be the Same in Retirement
The root of the problem, as Sall sees it, is that people assume that if they’re paying 22% tax on the money that’s going toward a Roth today, they’ll likely owe at least 22% tax on other income in retirement. But that’s perhaps not how it will pan out.
Are You Retirement Ready?
“You’re way more likely to have a lower income in retirement than you have today, so you’ll likely be in a lower tax bracket in the future,” Sall said. “You can see this from current retirees. Instead of earning a household income of $70,784 (the median household income), they’re earning just $47,620. After the standard deduction, they only owe $1,992 in taxes each year, which is a 4.2% effective tax rate. You’re paying 22% tax today to save 4.2% in retirement. No thanks.”
What You Can Save in Taxes Today Is Not Equal to the Taxes You Can Save in the Future
The second reason a Roth IRA isn’t the right choice for most Americans is a bit trickier to comprehend, but it comes down to the fact that the amount you can save in taxes today (by investing in a traditional IRA) is not apples to apples when compared to the taxes you can save in the future (by investing in a Roth today).
“It comes down to the marginal tax rate vs. the effective tax rate,” Sall said. “The effective tax rate is the average tax you pay. So with our laddered tax system, you pay 10% on some income, 12% on the next step and then perhaps 22% if you make enough, and so on. If you earn $122,000 in a year, you’ll have an effective tax rate of 9.8%. You pay $11,980, which is 9.8% of your income of $122,000.”
But wait, there’s more. Take a deep breath, because it gets pretty complex.
“The marginal tax rate is the tax rate of the bracket you’re in. So at a $122,000 income, you’re in the 22% tax bracket, so your marginal tax rate is 22%,” Sall explained.
Are You Retirement Ready?
“If you put your money in a traditional IRA, you’re deferring the marginal tax rate (the upper tier tax bracket) so you can pay the effective tax rate (the average rate) in retirement. In other words, you’re saving yourself 22% in taxes today if you agree to pay a 9.8% tax in retirement (assuming the same income and same tax rates). Ummm … yeah, I’ll defer taxes! But if you invest in a Roth, that means you’re paying 22% tax today so you can save 9.8% in retirement. No thanks. Bad deal!”
How To Figure Out Whether a Roth Is Right for You
One could go on and on about the complexities that make investing in a Roth IRA a poor financial choice for so many Americans. But there are situations wherein doing so could be a smart choice. To simplify the question of whether or not you should opt for a Roth, use this free Roth calculator.
“Chances are, [you] should avoid the Roth,” Sall said. “But if [you’re] young, contribute a ton to retirement and plan to produce a huge income in later years, then a Roth may still be for [you].”
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FAQs
It is possible to lose money in a Roth IRA depending on the investments chosen. Roth IRAs are not 100% safe, but they offer the potential for growth over time. Market fluctuations and early withdrawal penalties can cause a Roth IRA to lose money.
Does Roth IRA count as retirement savings? ›
A Roth IRA is an Individual Retirement Account to which you contribute after-tax dollars. While there are no current-year tax benefits, your contributions and earnings can grow tax-free, and you can withdraw them tax-free and penalty free after age 59½ and once the account has been open for five years.
Why is my Roth 401k losing money? ›
Stock market crashes can lead to 401(k) losses, but often, these are only short-term setbacks. As long as you've diversified your savings among many companies and sectors and you're not investing too aggressively for your risk tolerance, you will likely see your portfolio rebound in time. Patience is key here.
What happens to a Roth IRA when you retire? ›
If you've met the five-year holding requirement, you can withdraw money from a Roth IRA with no taxes or penalties. Remember that unlike a Traditional IRA, with a Roth IRA there are no required minimum distributions.
Can I write off losses in Roth IRA? ›
The Internal Revenue Service does not permit you to deduct losses from your Roth IRA on a year-to-year basis, so the only way to deduct your losses is to close your Roth IRA accounts.
What is the 5 year rule for Roth IRA? ›
The Roth IRA five-year rule says you cannot withdraw earnings tax-free until it's been at least five years since you first contributed to a Roth IRA account. This five-year rule applies to everyone who contributes to a Roth IRA, whether they're 59 ½ or 105 years old.
What is a disadvantage of using a Roth IRA for retirement savings? ›
One disadvantage of the Roth IRA is that you can't contribute to one if you make too much money. The limits are based on your modified adjusted gross income (MAGI) and tax filing status.
Should I keep money in savings or Roth IRA? ›
Savings accounts can be a safe place to keep cash for emergencies and short-term goals. Roth IRAs are for long-term goals, primarily retirement. However, Roth IRAs can also be used for withdrawals in an emergency because your Roth contributions are always accessible without penalty. However, your earnings are not.
Can I lose my investment in Roth IRA? ›
A Roth IRA can lose money like any investment. Losses may result from poor investment selection, market volatility, early withdrawals and investment fees. You can avoid losses by diversifying, watching fees closely, investing in safe assets and avoiding early withdrawals.
What does Dave Ramsey say about Roth 401k? ›
Take the Roth! If you put your money into a Roth 401(k), and by retirement age there's $1 million in there, that money is yours tax-free. By comparison, if it's in a regular 401(k), you'll pay taxes on that $1 million, which will come out to about $300,000 — maybe $400,000 at the rate things are going now.
You might need some help from your broker or financial advisor if this is the case; they'll be able to help you assess what went wrong and whether there's anything you could have done differently in order to avoid losing money on your investment.
Are Roth IRAs in danger? ›
Are Roth IRAs safe? Every investment carries risk, so you have to decide whether a Roth IRA aligns with your financial situation and goals. Also note that a Roth IRA is simply a tax-advantaged account you use to invest; the investments are what carry risk.
When should you stop investing in a Roth IRA? ›
With a traditional IRA, you must stop making contributions at age 73. Roth IRAs come with no such rule. In turn, you can continue contributing to it for as long as you live, making them valuable assets for those who want to build up wealth to transfer to their heirs.
Should a retired person invest in a Roth IRA? ›
Even when you're close to retirement or already in retirement, opening this special retirement savings vehicle can still make sense under some circ*mstances. There is no age limit to open a Roth IRA, but there are income and contribution limits that investors should be aware of before funding one.
Why isn't my Roth IRA making money? ›
There are two primary reasons your IRA may not be growing. First, you can only contribute a certain amount of money to your IRA each year. Once you hit that limit, your account cannot grow via personal contributions until the following year. This may also mean you are not making contributions when you believe you were.
Why is my Roth IRA rate of return so low? ›
Depending on your investment choices, you may be able to earn an average annual return between 7% and 10%. Of course, you may earn less. If your Roth IRA is full of low-risk bonds, you will probably earn a lower return. If your Roth is full of growth stocks, you might earn a higher return over a long time period.
How much will a Roth IRA grow in 20 years? ›
If you contribute 5,000 dollars per year to a Roth IRA and earn an average annual return of 10 percent, your account balance will be worth a figure in the region of 250,000 dollars after 20 years.
Should I keep any cash in my Roth IRA? ›
A Roth IRA can double as an emergency savings account, which means you can withdraw contributed sums at any time without taxes or penalties. Roth funds should only be withdrawn as a last resort. Be sure to limit the sum to your contributions, which means don't dip into earnings or you will likely be penalized.
