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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].”
FAQs
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 guaranteed rate of return on a Roth IRA? ›
Depending on your investment choices, you may be able to earn that 6% to 7%, or potentially more. You may also earn less, or lose money. If your Roth IRA is full of low-risk bonds, you may earn a lower, but potentially more consistent, return year to year.
Is 400k in your 401k good? ›
In retirement, this can be just as valuable. With a $400,000 retirement account, a 10% annual rate of return would give you $40,000 per year without ever drawing down on the principal.
What does Suze Orman say about Roth IRA? ›
Orman explained that you should make it a priority to fund your Roth IRA to the maximum allowable amount. “I hope you will make it a goal to save up to your 2024 limit,” she wrote. “And you know that I think it's smart to save in a Roth IRA because when you retire, all your withdrawals will be 100% tax-free.”
What to do when your IRA is losing money? ›
Make sure your investments are well diversified
The first thing you should do if your 401(k) or individual retirement plan (IRA) is losing money is to check that you are well diversified. You want your money distributed among many stocks, bonds, and other investment products.
What happens if I empty my Roth IRA? ›
Generally, early withdrawal from an Individual Retirement Account (IRA) prior to age 59½ is subject to being included in gross income plus a 10 percent additional tax penalty. There are exceptions to the 10 percent penalty, such as using IRA funds to pay your medical insurance premium after a job loss.
How much does a Roth IRA grow in 10 years? ›
Let's say you open a Roth IRA and contribute the maximum amount each year. If the base contribution limit remains at $7,000 per year, you'd amass over $100,000 (assuming a 8.77% annual growth rate) after 10 years. After 30 years, you would accumulate over $900,000.
What is the average retirement savings by age? ›
The above chart shows that U.S. residents 35 and under have an average of $30,170 in retirement savings; those 35 to 44 have an average $131,950; those 45 to 54 have an average $254,720; those 55 to 64 have an average $408,420; those 65 to 74 have an average $426,070; and those over 70 have an average $357,920.
How much will Roth IRA be worth 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.
How long would $400,000 last in retirement? ›
Safe Withdrawal Rate
Using our portfolio of $400,000 and the 4% withdrawal rate, you could withdraw $16,000 annually from your retirement accounts and expect your money to last for at least 30 years. If, say, your Social Security checks are $2,000 monthly, you'd have a combined annual income in retirement of $40,000.
Not factoring in additional income from other sources or taking taxes into account, if you retire at 65 and plan to spread $400,000 across 15 years up to a life expectancy of 85, you'll receive, at minimum, $34,000 annually. This is if you factor in 2% inflation and an annual yield of 6%.
Can I retire at 62 with $400,000 in my 401k? ›
Can I Retire at 62? You can retire a little early on $400,000, but it won't be easy. If you have the option of working and saving for a few more years, it will give you a significantly more comfortable retirement.
Do billionaires use Roth IRAs? ›
But the tax incentives that the new accounts provided weren't lost on the rich or their accountants. In recent decades, with the advent of the Roth IRA and relaxed restrictions on IRA rollovers, ultrawealthy Americans have reportedly built tax-sheltered accounts worth many millions—or even billions—of dollars.
At what age should you not invest in a Roth IRA? ›
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.
Who should not do a Roth IRA? ›
The tax argument for contributing to a Roth can easily turn upside down if you happen to be in your peak earning years. If you're now in one of the higher tax brackets, your tax rate in retirement may have nowhere to go but down.
What happens to Roth IRA if the market crashes? ›
Market fluctuations and early withdrawal penalties can cause a Roth IRA to lose money. Investing late or contributing too much can also result in potential losses. Diversification and considering time horizon can help mitigate risks in a Roth IRA.
What happens if I sell a stock in my Roth IRA for a loss? ›
Roth IRA Tax Rules
As long as your Roth IRA has been open more than five years and you're older than 59½—no matter how often you bought and sold investments in the account—you do not owe taxes on any of your gains. The flip side to this is that you don't get a tax deduction when you sell investments for a loss.
Is there risk in a Roth IRA? ›
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.
Can I get my money back from a Roth IRA? ›
Roth IRA 5-Year Rule
You can generally withdraw your earnings without owing any taxes or penalties if you're at least 59½ years old and it's been at least five years since you first contributed to your Roth IRA. This is known as the five-year rule.
