There's a reason so many people opt to save for retirement in a Roth IRA: Not only do these plans offer the benefit of tax-free investment gains and tax-free withdrawals during retirement, but they also don't impose required minimum distributions like traditional retirement savings plans do. And not having to remove money from your account every year gives you the option to continue enjoying tax-free growth throughout retirement.
Roth IRAs are also extremely flexible in that you can generally withdraw your principal contributions at any time without penalty. With a traditional IRA or 401(k) plan, withdrawals taken prior to age 59 1/2 are commonly subject to penalties.
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Now, the logic there is simple: The IRS figures that since you're not getting any sort of tax break on the money you put into your Roth IRA, it shouldn't penalize you for taking your money out, even if you haven't yet reached retirement age.
You should also know that you can take a penalty-free withdrawal from your Roth IRA to pay for a first-time home. And, you can tap your Roth IRA penalty-free to pay for college.
But while it's a nice thing in theory that Roth IRAs offer so much flexibility, the option to withdraw funds without penalty could actually cause you a pretty big problem.
Don't keep tapping your Roth IRA
Some people open a Roth IRA for the express purpose of saving for college. But if you have your Roth IRA earmarked for retirement, it's best to not remove any funds from it ahead of your senior years.
Sure, you might have the option to take a Roth IRA withdrawal to help buy a home or cover some unplanned bills. But remember, every dollar you remove from your Roth IRA ahead of retirement is money you won't have later in life, when you're likely to need it the most.
Plus, when you take money out of a Roth IRA, you don't just lose out on principal -- you also lose out on investment gains.
So, let's say the investments in your Roth IRA typically generate an average annual 8% return, which is a bit below the stock market's average. If you take a $5,000 Roth IRA withdrawal 25 years ahead of retirement, removing that sum could actually end up costing you over $34,000 when you account for lost gains.
Remember what that money is there for
Roth IRAs may be extremely flexible, but that doesn't mean you should tap yours at any opportunity. One of the biggest mistakes you might make with your Roth IRA is raiding your account ahead of retirement and then having less money to fall back on during your senior years.
A better bet is to set aside money in a regular savings account and use that for emergencies. And if you're trying to meet a major goal, like buying a house or funding a college education, open up separate accounts specifically for those purposes.
The money you're putting away for retirement is money you shouldn't touch until your career wraps up -- period. Stick to that plan, and you're more likely to avoid financial stress once you stop working completely.
