Even America’s greatest retirement tool has its drawbacks.
Americans have a bevy of retirement tools to choose from, but it’s been argued that the Roth IRA is the greatest retirement tool of them all.
At the heart of the debate is the Roth IRA’s tax treatment. A Roth IRA is funded with after-tax dollars, meaning investment gains within a Roth are completely free of taxation for the life of the account. Additionally, contributions to a Roth IRA (but not investment gains) can be withdrawn at any time, there are no required minimum distributions, and there’s no maximum age at which you must stop contributing. All in all, the Roth IRA does offer a great combination of long-term growth opportunity and financial flexibility.
Say no to a Roth IRA?
However, nothing is perfect — not even the Roth IRA.
In particular, the Roth IRA has six disadvantages that could make it a far less appealing retirement tool than you realize. If one or more of these reasons hits home for you, then it could be worth saying no to a Roth IRA.
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1. You have a short time horizon
One of the prime advantages of the Roth IRA is that it allows time and compounding to work their magic. But for retirees in their 80s, 90s, and up, those advantages may not be worthwhile.
Money contributed into a Roth IRA can be withdrawn at any time, for any reason. However, investment gains within a Roth IRA fall under the “five year rule”: Accountholders aren’t allowed to withdraw investment gains for five years following their initial contribution, which may not make sense for elderly Americans who will need their savings during retirement. If you withdraw investment gains before this five-year period is up, you could face ordinary income taxes and a penalty on top of it.
2. Your employer offers a better option
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While the tax advantages of a Roth IRA are hard to beat, the $5,500 annual contribution for workers aged 49 and under, and $6,500 for those 50 and up, pales in comparison to what you can contribute to a 401(k) through your employer. The 401(k) contribution limit in 2016 is $18,000 for workers aged 49 and under and $24,000 for workers aged 50 and up. Plus, quite a few employers that offer a 401(k) match a percentage of their employees’ annual salary. Free money from your employer is hard to turn down, which is why a 401(k) could be the better choice in some instances.
Some 401(k)s also have lower fees on mutual funds thanks to the bargaining power of large plan providers. And these days, Roth 401(k)s are gaining popularity, offering many of the same tax benefits as a Roth IRA.
3. You plan to leave most of your assets to charity
Are you planning to give a large portion of your money to charity once your pass on? Then chances are you’re giving your money to an organization that already enjoys tax-free status. It wouldn’t make much sense for you to pay tax on money that would be going into a tax-free account since the donation upon your death will be headed to a tax-sheltered entity. Instead, it makes more sense to contribute to a tax-deferred investment tool, such as a Traditional IRA or 401(k), which gives you the benefit of an upfront tax deduction.
4. You worry about the future tax treatment of the Roth IRA
Another reason you might choose to forgo a Roth IRA is based on the fear of changes to the future tax treatment of these plans. There’s absolutely zero predictability in deciphering what Congress will do next, which means there’s always a possibility that the tax treatment of Roth IRAs could be changed in the future to perhaps add a surtax, or something of that nature. With a Traditional IRA you would receive an upfront tax break in the form of reduced current-year tax liability since the money you contribute is before-tax dollars. For some people, the certainty of this deduction might be appealing.
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5. Your ordinary income tax status is expected to stay the same or drop during retirement
The grandiose point of the Roth IRA is to minimize what you’ll ultimately owe in federal taxes to the IRS. However, the Roth IRA isn’t always the best solution to that end, despite its tax-free status. If your current ordinary tax rate is expected to stay the same during retirement, or even fall, it could be worthwhile to choose a Traditional IRA or 401(k) (if offered) instead.
The perfect candidate to consider a Roth IRA would be a worker in a relatively low tax bracket with time on their side. Comparably, a top-earning individual is more likely to see his or her tax rate fall during retirement, meaning the potential for an upfront deduction with a tax-deferred plan could be more appealing.
6. Conversion expenses could cost you your comfortable retirement
Finally, it can be tempting to consider converting a traditional IRA, or other qualified investment vehicle, into a Roth IRA, especially if you have plenty of years left ahead of you. A Roth conversion can also allow high earners to get around the Roth IRA’s income-based contribution limits. However, converting to a Roth IRA may not always be in your best interests.
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For example, when converting funds from an investment account that offers an up-front tax benefit to a Roth IRA, which is funded with after-tax dollars, you’ll be required to pay ordinary income taxes on those funds. If you don’t have enough spare cash on hand to pay this tax, then you could be in for a rude awakening. If you’ve made a lot of money in your tax-deferred plan, it could mean paying tax at the highest rate, 39.6%. Sometimes staying the course with a qualified investment plan is your best option.
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Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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