When it comes to choosing a retirement plan, you have options. You can sign up for your employer's 401(k) and have funds deducted automatically from your earnings each pay period. Or, you can open an IRA, which is a good option if you don't have access to a 401(k).
Of course, not all IRAs are created equal, and you may be looking at opening a Roth IRA. With a Roth IRA, you won't get an immediate tax break on the contributions you make. You will, however, get to enjoy tax-free investment growth in that account, and your withdrawals will also be tax-free during retirement. That could make managing your money a lot easier as a senior. Plus, if you expect to be in a higher tax bracket in retirement than you're in now, a Roth IRA makes sense.
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But that's not the only reason Roth IRAs are so popular. A lot of savers like them for the flexibility they offer. But in reality, that may not be such a good thing.
Why too much flexibility in your retirement plan can backfire
If you remove funds from a traditional IRA (or 401(k) plan) before reaching age 59 1/2, you'll incur a 10% early withdrawal penalty on your distribution. But with a Roth IRA, you can actually remove your principal contributions at any time without penalty.
The reason? Traditional retirement plan contributions are made with pre-tax dollars, so there's an instant tax benefit to be reaped. Roth IRAs work the opposite way -- they're funded with after-tax dollars, and so the IRS figures if you never got a tax break on that money in the first place, why should you be penalized for removing it early?
Now this rule only applies to the money you put into your IRA -- not your investment growth. If you contribute $10,000 that grows to $12,000, that $2,000 in gains can't be removed early without penalty. But your $10,000 is fair game.
That may seem like a great thing initially. Say you run into a financial emergency and need money in a pinch. You can tap your Roth IRA to cover anything from home repairs to a down payment for a new car.
But if you allow yourself to fall back on your Roth IRA as an emergency fund, you'll risk falling short when it comes to retirement itself. Similarly, if you give yourself permission to dip into your Roth IRA when you want money for travel, home renovations, or other purposes, you'll risk not having enough savings on hand by the time retirement rolls around.
That's why if you're going to save in a Roth IRA, you'll really need to promise yourself you'll leave that money alone. And if you don't trust yourself to do so, you might consider housing your savings in a traditional retirement plan -- one where there's more to lose if you tap it early.
Remember, your retirement isn't going to pay for itself. Social Security will provide some income, but it's not enough for most seniors to live comfortably. You'll need savings of your own to enjoy your senior years without financial worry, and if you take too much advantage of the flexibility Roth IRAs have to offer, you could wind up seriously short on cash later in life.
