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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].”
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FAQs
Report the amount of your Roth IRA loss as a miscellaneous deduction. This amount is added to your other miscellaneous deductions and then you must subtract 2 percent of your adjusted gross income to ascertain your deduction value.
What is a reasonable rate of return on retirement savings? ›
Generating sufficient retirement income means planning ahead of time but being able to adapt to evolving circ*mstances. As a result, keeping a realistic rate of return in mind can help you aim for a defined target. Many consider a conservative rate of return in retirement 10% or less because of historical returns.
What happens if you exceed Roth IRA income limit? ›
The IRS puts annual income limits on a Roth IRA. When you exceed that limit, the IRS generally charges a 6% tax penalty for each year the excess contributions remain in your account. This is triggered at the time you file each year's taxes, giving you until that deadline to remove or recharacterize the misplaced funds.
What is the return rate for 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%.
Can I get my money back from a Roth IRA? ›
If you've met the five-year holding requirement, you can withdraw money from a Roth IRA with no taxes or penalties. Remember that unlike a Traditional IRA, with a Roth IRA there are no required minimum distributions.
Why is my Roth 401k 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.
Is 500k 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.
Is a 7% return realistic? ›
While quite a few personal finance pundits have suggested that a stock investor can expect a 12% annual return, when you incorporate the impact of volatility and inflation, 7% is a more accurate historical estimate for an aggressive investor (someone primarily invested in stocks), and 5% would be more appropriate for ...
Can I retire at 60 with 500k in savings? ›
You could retire at 60 with 500k, but it depends on what sort of retirement lifestyle you hope to enjoy.
What is Roth backdoor? ›
A “backdoor” Roth IRA allows high earners to sidestep the Roth IRA's income limits by converting nondeductible traditional IRA contributions to a Roth IRA. That typically requires you to pay income taxes on funds being rolled into the Roth account that have not previously been taxed.
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 can I withdraw money from my Roth IRA without penalty? ›
Withdrawing over age 59½
If you are over age 59½ and have met the five-year rule, withdrawals from a Roth IRA are penalty and tax-free. This includes any earnings in the account in addition to your original contributions.
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.
Why is my Roth IRA not growing? ›
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.
How much should I put in my Roth IRA each month? ›
If your income permits, you should max out your Roth each year. For someone under 50, the maximum annual contribution is $7000. That would be about $583 per month. A Roth IRA is a special individual retirement account (IRA) in which you pay taxes on contributions, and then all future withdrawals are tax-free.
Should I be worried if my Roth IRA is losing money? ›
A Roth IRA can lose money like any investment. Losses may result from poor investment selection, market volatility, early withdrawals and investment fees. You can avoid losses by diversifying, watching fees closely, investing in safe assets and avoiding early withdrawals.
Will my Roth IRA grow if I don't invest? ›
Roth IRAs grow through compounding, even during years when you can't make a contribution. There are no required minimum distributions (RMDs), so you can leave your money alone to keep growing if you don't need it.
Can I write off stock losses? ›
You can't simply write off losses because the stock is worth less than when you bought it. You can deduct your loss against capital gains. Any taxable capital gain – an investment gain – realized in that tax year can be offset with a capital loss from that year or one carried forward from a prior year.
