If you're saving money for retirement, you have choices. You could open a regular brokerage account and save your money there. But if you go that route, you don't get any tax breaks in the process.
On the other hand, if you opt to save for retirement in an IRA, there are plenty of tax benefits to enjoy. With a traditional IRA, your contributions go in tax-free up to a limit set by the IRS each year. Investments in your account also get to grow on a tax-deferred basis, so you don't pay taxes on your gains until you start taking withdrawals.
Roth IRAs, meanwhile, are funded with after-tax dollars, so your contributions don't exempt a portion of your income from taxes like a traditional IRA. But Roth IRAs give you tax-free investment gains and tax-free withdrawals in retirement, so you don't have to worry about paying the IRS a portion.
Also, Roth IRAs do not impose required minimum distributions like traditional IRAs. You can let your money sit in your account and continue to grow if you don't need to take withdrawals for a good part of retirement. Remember, Roth IRA investment gains are tax-free, so it's beneficial to let that money sit and grow for longer.
But another feature that's often hailed as a benefit of Roth IRAs is the flexibility to withdraw your principal contributions (not the gains portion of your account) before age 59 1/2 without penalty.
With a traditional IRA, a penalty applies when you take withdrawals prior to 59 1/2 with just a few exceptions. But this so-called Roth IRA perk might actually be a huge drawback.
When it's far too easy to get your money out
Because Roth IRAs are funded with after-tax dollars, the IRS won't penalize you for removing your money early. The way the agency sees it, you didn't get a tax break on those contributions, so as long as you touch your principal only, and not your gains, you can do what you want with your money.
Let's say you put $5,000 into a Roth IRA that grows into $8,000 after a few years. You're OK to remove the $5,000 you put in initially without a penalty before age 59 1/2. But if you touch the $3,000 gains portion, a penalty could apply.
You might think that the ability to access your money early is a nice thing. It could come in handy in the event of a financial emergency, for sure.
But remember, the money in your Roth IRA is supposed to be earmarked for -- you guessed it -- retirement. If you take a withdrawal before retirement, even if it's for a good reason, you'll have that much less money in retirement.
How much less? Say you remove $5,000 at age 40. If your Roth IRA is normally invested at an average annual 10% return, which is in line with the stock market's average, and you retire at age 65, then you're actually out a little over $54,000 when you account for lost gains on that $5,000 over 25 years. That's a lot of retirement income to give up.
Set strict ground rules with yourself if you're going to save in a Roth IRA
A Roth IRA could be a great tool for growing your retirement nest egg. But if you're going to use one, tell yourself that you're absolutely not allowed to remove funds from that account ahead of retirement.
Remember, the whole purpose of saving in an IRA -- Roth or traditional -- is to have enough money to cover your expenses and enjoy your life once your career comes to an end. If you keep tapping your savings because it's easy enough to do so, you're going to defeat the purpose of funding that account in the first place.
