One of the most powerful investing tools available to investors who are saving for retirement is the Roth IRA. Yet even though Roth IRAs have the potential to save you thousands of dollars in taxes, there are still some situations where you might be better off using some other method for your retirement savings.
Balancing benefits
The primary benefit of the Roth IRA is that once you make your contribution, your savings grows tax-free regardless of how much income your investments generate within the IRA. Moreover, as long as you meet the rules for taking money out of your Roth, you won't have to pay tax on the amounts you withdraw, either.
For many investors, that's a big advantage over traditional IRAs and 401(k) plans, with which you get an immediate tax break but have to pay taxes when you take withdrawals during retirement. Yet in trying to decide where your savings will make the biggest impact on your retirement, you should also take into account some other contributing factors that may swing the balance against using a Roth. Here are a few:
1. You're missing out on a match.
Lately, the only thing most people have heard about employer matching contributions to 401(k) plans is how many companies have stopped making them. Recently, American Express (NYSE:AXP) added its name to the long list of employers, including FedEx (NYSE:FDX), that have suspended matching contributions to employees' 401(k) accounts. Given the controversy over hidden fees and lousy investment choices in many 401(k) plans, some are already concerned about whether 401(k)s make sense, even considering the free money that a match provides.
If you're still getting a match, though, it usually makes sense to take it -- unless your plan is a real dog. Choosing the least objectionable investment option, such as an index fund, may not be exactly what you'd do given unlimited choices, but with some plans still doubling your money with a match, you can't afford to pass it up.
2. Your taxes are headed down.
When you use a Roth IRA, you give up the immediate tax deduction that you could get from a 401(k) or a traditional IRA contribution. The tax-free growth you get from a Roth certainly offsets the loss of that deduction, but in some cases, it may never fully make up for it.
For instance, say that five years ago, you had $3,000 to invest. Your federal tax rate was 35%, plus an additional 5% in state tax. Now consider two choices: You could either put $3,000 in a Roth, or you could have put $5,000 in a 401(k), which would have given you $2,000 back in tax breaks. Then say you build a portfolio with the following five stocks:
|
Stock |
Value in Roth IRA |
Value in 401(k) |
|---|---|---|
|
Agrium (NYSE:AGU) |
$8,598 |
$14,330 |
|
Marvel Entertainment (NYSE:MVL) |
$6,869 |
$11,449 |
|
Nike (NYSE:NKE) |
$4,661 |
$7,769 |
|
Qualcomm (NASDAQ:QCOM) |
$4,341 |
$7,234 |
|
Schlumberger (NYSE:SLB) |
$5,415 |
$9,025 |
Source: Yahoo! Finance.
Now as you can see, the value in the Roth is much less -- about $30,000 versus $50,000 in the 401(k) -- as the Roth represents after-tax money. But if you're in a low tax bracket in retirement -- perhaps from a combination of lower income, higher deductible expenses, or having moved to a lower-tax state -- then you might not end up paying a full $20,000 in taxes on your 401(k). And while many see tax rates going up rather than down in the coming years, your own financial situation may clearly suggest a lower future tax rate -- which weighs against choosing a Roth.
3. Are big changes in taxes coming?
Lately, some have talked about reforming the federal tax structure to add a consumption-based value-added tax (VAT). If a VAT ends up lowering income tax rates or replacing the income tax outright, then you clearly want to get deductions now while they still have maximum value.
That means if you could get a current deduction on a traditional IRA or 401(k), then you'd want to grab it. Those who used Roth IRAs would find that they'd still have to pay VAT on their expenses, effectively neutralizing the tax break on that money.
Do your best
Of course, there's a lot of uncertainty about all of these factors. But it makes sense to at least consider what impact they'd have on various types of retirement accounts. While many will still find that Roth IRAs are the better choice, you may conclude that you'd be better off doing something else with your savings.
For more on making the most of your retirement:
- How you can retire without being a billionaire.
- Don't wait another day to start investing.
- You're not automatically set for life.
