Many financial advisers believe that Roth individual retirement accounts are the best way available for you to save for retirement. With income tax rates having gone up in 2013 and with further increases potentially on the horizon, a retirement account that promises tax-free treatment not only while your money is invested within the account but also when you decide to make distributions is extremely valuable.
Yet choosing a Roth IRA over other retirement-saving choices comes at a cost -- and for many taxpayers, it's too high a price to pay.
Your Tax Rate Isn't Going to Get Any Higher
The general idea behind a Roth IRA is that by making after-tax contributions, you get the benefit of tax-free growth throughout your career and tax-free withdrawals in retirement. %VIRTUAL-article-sponsoredlinks%But the tradeoff is that you give up the potential deduction you might be eligible to receive by making contributions to a traditional IRA or 401(k) account.
Whether that tradeoff is worth it depends on several factors, but the most important compares your current tax rate with what you expect to pay after you retire.
If you're in the prime of your career and have earnings that put you in the maximum tax bracket, the value of getting a tax deduction on traditional retirement-account contributions is extremely high. So using a Roth and giving up that deduction doesn't make much sense. For those who are just getting started and are in low tax brackets, it's a lot easier to justify giving up a smaller deduction now in exchange for big tax savings later.
Your Employer Gives You a Better Deal
Roth IRAs don't offer one thing that many workers get from their 401(k) plans: matching contributions from their employers.
If you only have a limited amount to save for retirement, your first priority should generally be to contribute to your workplace 401(k) at least to maximize your employer match. After you've claimed all the free money your employer is willing to give, then it can be smart to look at a Roth as a secondary option. But with many employers offering matching contributions when you contribute as much as 6 percent or more of your salary, doing both 401(k) and a Roth might be more than you can afford.
You're Scared of Washington
What the tax laws give, tax law changes can take away. For instance, the latest administration budget proposal would set maximums on the amount of tax-favored retirement savings that you can set aside, as well as other provisions that would impose required minimum distributions on Roth IRAs for the first time. Some analysts worry that more substantive changes could be next, including potentially adding a surtax to Roth IRA distributions to effectively remove their tax-free status.
The advantage of traditional IRAs is that you grab your deduction up front, making it impossible for lawmakers to take it away later. Although most believe that the chances of major Roth IRA changes are remote, those who are risk-averse should consider that possibility in choosing their retirement vehicle.
For the best chance of maintaining your lifestyle in retirement, aim to contribute 15% of your salary, including any employer match, to your 401(k) or other savings account throughout your career (see What's Your Retirement Number?). Most people fall short of that benchmark. The average employee contribution to a 401(k) is 6% to 8%.
Saving 15% may seem like lifting weights at the gym for several hours. Try it anyway, says Stuart Ritter, a financial planner and vice-president of T. Rowe Price Investment Services. "Kick your contribution level up to 15% for three months. At the end of the three months, you can lower it, if necessary." But rather than dipping back to single digits, go with 10% or 12%, he says. "People find they can settle on a much higher amount than they were contributing before."
Procrastination is another risk: With each year you neglect to save, you lose an opportunity to fuel your accounts and to let compounding keep the momentum going.
So powerful is the effect of saving early that you could have less trouble catching up if you take a several-year break-say, to pay for college-than if you wait until midlife to start. At that point, says George Middleton, a financial adviser in Vancouver, Wash., "the amount of money you have to put away can be ungodly."
Still, you can make headway, especially if your kids are grown and you have fewer expenses. Say you're 55, earn $80,000 a year and have nothing saved for retirement. You put the pedal to the metal by setting aside $23,000 in your 401(k) each year for the next ten years. That $23,000 combines the annual maximum for people younger than 50 ($17,500 in 2013) plus the annual catch-up amount for people 50 and older ($5,500). If your employer matches 3% on the first 6% of pay and your investments earn an annualized 7%, you'd amass $434,700 by the time you reached 65.
For some investors, a bad case of the jitters became a bigger derailer than the recession itself (see How to Learn to Love [Stocks] Again). "People got very nervous and became more conservative, so when the market came back up, they had less of their portfolio participating in the rally," says Suzanna de Baca, vice-president of wealth strategies at Ameriprise Financial.
You can get back in (and stay in) by investing in stocks or stock mutual funds in set amounts on a regular basis. Using this strategy, known as dollar-cost averaging, you automatically buy more shares at lower prices and fewer shares at higher prices-an antidote to market-driven decisions. Once you decide on your mix of investments, use automatic rebalancing to keep it that way, advises Debbie Grose, of Lighthouse Financial Planning, in Folsom, Cal.
Most financial planners recommend that your portfolio be at least 80% in stocks in your twenties, gradually shifting to, say, 50% stocks and 50% fixed-income investments as you approach retirement. But formulas don't cure panic attacks. "Set your risk at the level you're willing to withstand in a downturn," says Middleton.
Amassing hundreds of thousands of dollars for retirement is challenge enough, but parents are also expected to save $80,000 to $100,000 per kid to cover the college bills. In fact, half of parents don't save for college at all, and the average savings among those who do runs about $12,000, according to a 2013 report by Sallie Mae, the financial services institution. Faced with a shortfall, two-thirds of families say they would use their retirement savings to pay for their children's college education, if necessary.
Don't wait until your kid is 17 to discuss how much you'll contribute. Have a conversation early about how much you can afford to give, says Fred Amrein, a registered financial adviser in Wynnewood, Pa.
A Roth IRA can be one way to save for both college and retirement, although it won't get you all the way to either goal. You can contribute up to $5,500 a year ($6,500 if you're 50 or older) in after-tax dollars, and the money grows tax-free. You can withdraw your contributions for any reason, including college, without owing tax on the distribution. You will pay taxes on the earnings (unless you're 59 1/2 or older and have had the account for at least five calendar years), but you won't have to pay a 10% early-withdrawal penalty if you use the money for qualified higher-education expenses.
Leaving the workforce, even temporarily, deprives you of current income and makes it tougher than ever to save for retirement. You might even find yourself tapping your retirement accounts to cover day-to-day expenses. You'll owe taxes on distributions from a traditional IRA plus a 10% penalty if you're younger than 59 1/2.
The best way to avoid that dismal situation is to have an emergency reserve that covers at least six months or even a year of living expenses, says Jim Holtzman, a certified financial planner in Pittsburgh. He acknowledges, however, that "that's easy to recommend and hard to implement." Avoid further disaster by hanging on to health insurance: If you can't get coverage through your spouse, look into keeping your employer-based coverage through COBRA. You can extend that coverage for up to 18 months, although you'll pay the full premium plus a small administrative fee. As of January 2014, you'll also have access to coverage through state health exchanges.
Married couples who depend on each other's earning power need life insurance to cover the gaps when one spouse dies. You can get a rough idea of how much coverage you'll need on each life by calculating what you each contribute to annual living expenses and multiplying that amount by the number of years you expect to need it, says Steve Vernon, of Rest-of-Life Communications, a retirement consulting firm. (For advice on how to do a more precise calculation, see How Much Life Insurance Do You Need?)
If you have a pension, you'll have the option of choosing a single-life benefit, which ends at your death, or the standard joint and survivor's benefit, which pays less while you're alive but keeps paying (typically at 50% to 75% of the benefit) for the rest of your spouse's life. Your spouse is legally entitled to the survivor's benefit and must sign a waiver to forgo it. Don't be tempted by the higher-paying single-life option if your spouse will need the survivor's benefit later.
Decisions you make in claiming Social Security are similarly key. If you're the higher earner (typically, the man), "you will really help your spouse by delaying Social Security as long as possible," says Vernon. The benefit grows by about 6.5% to 8% a year for each year you delay after age 62, when you first qualify, until you reach age 70. If you die first, your spouse can qualify for a survivor's benefit up to the full amount you were entitled to, depending on the age at which she files.