fizkes / iStock.com
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].”
More From GOBankingRates
- Frugal People Love the 6 to 1 Grocery Shopping Method: Here's Why It Works
- 6 Cities Where Social Security Goes the Farthest for Retirees
- The 6 Smartest Things to Do With Your Tax Refund
- 7 Ways Fraudsters Are Trying to Scam People in 2024
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.
Can you lose money in a Roth 401 K? ›
Can You Lose Money in a Roth 401(k)? You can lose money in any investment if the market tanks.
What is the return rate on a Roth IRA? ›
What's the average Roth IRA interest rate? Roth IRAs aren't investments and don't pay interest or earn interest, but the investments held within Roth IRAs may earn a return over time. Depending on your investment choices, you may be able to earn an average annual return between 7% and 10%.
What is a reasonable rate of return on retirement savings? ›
Many consider a conservative rate of return in retirement 10% or less because of historical returns.
What to do when IRA is losing money? ›
The key, however, is to stay cool when that happens and not rush to sell off investments in that account when they're down. If you do that, you'll lock in your losses. If you sit tight, you can give your IRA a chance to recover, which it's likely to do.
What happens if I empty my Roth IRA? ›
The early withdrawal penalty for a traditional or Roth individual retirement account is 10% of the amount withdrawn. Keep in mind that you may also owe income tax in addition to the penalty.
What is the downside to a Roth IRA? ›
Earnings can't be withdrawn tax-free until age 59½ and the account is at least 5 years old. Diversification in retirement, so all of your accounts aren't tax-deferred. The maximum contribution is relatively low compared with a 401(k). You'll probably need other accounts to save enough for retirement.
Why is my retirement account losing money? ›
There can be several reasons your 401(k) lost money, including a recession or stock market correction, your portfolio not being diversified enough, or investing too aggressively for your risk tolerance.
What to do when your investments are losing money? ›
"If you want to stay invested, sell at a loss and use the proceeds to buy into a similar, but not substantially identical, fund," Wybar says. "This way you can recoup the loss and participate in upside returns when the market goes back up."
What is a good amount in Roth IRA for retirement? ›
How much a Roth IRA will be worth is determined by its rate of return. In addition, thanks to the power of compounding, returns may eventually exceed contributions over time. Most experts suggest using 80% of your current income as a guide to help you plan your retirement savings.
The impact current interest rates have on your Roth IRA depends largely on how your Roth IRA is invested. If you have your Roth IRA assets invested in CDs, money market accounts, and other savings type investments, then changing interest rates can directly impact your returns.
How much will 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.
Is $500,000 in retirement savings good? ›
Most people in the U.S. retire with less than $1 million. $500,000 is a healthy nest egg to supplement Social Security and other income sources. Assuming a 4% withdrawal rate, $500,000 could provide $20,000/year of inflation-adjusted income. The 4% “rule” is oversimplified, and you will likely spend differently.
What is considered a good retirement savings? ›
By age 35, aim to save one to one-and-a-half times your current salary for retirement. By age 50, that goal is three-and-a-half to six times your salary. By age 60, your retirement savings goal may be six to 11-times your salary. Ranges increase with age to account for a wide variety of incomes and situations.
What is a realistic amount to save for retirement? ›
Our guideline: Aim to save at least 15% of your pre-tax income1 each year, which includes any employer match. That's assuming you save for retirement from age 25 to age 67. Together with other steps, that should help ensure you have enough income to maintain your current lifestyle in retirement.
What happens if you lose excess Roth IRA contributions? ›
The penalty for an ineligible contribution is 6% of the excess amount. You pay this penalty when you file your income tax return using IRS Form 5329. If you make too much money, you might be able to get around income limits with a backdoor Roth.
Can I get my money back from a Roth IRA? ›
You can withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free. However, you may have to pay taxes and penalties on earnings in your Roth IRA.
Why isn't my Roth IRA making money? ›
There are two primary reasons your IRA may not be growing. First, you can only contribute a certain amount of money to your IRA each year. Once you hit that limit, your account cannot grow via personal contributions until the following year. This may also mean you are not making contributions when you believe you were.
What is the 5 year rule for Roth IRA withdrawals? ›
The Roth IRA five-year rule says you cannot withdraw earnings tax-free until it's been at least five years since you first contributed to a Roth IRA account. This five-year rule applies to everyone who contributes to a Roth IRA, whether they're 59 ½ or 105 years old.
