Many people like to save for retirement in a traditional IRA because it offers an immediate tax break in that your money goes in tax free. So if you put $3,000 into a traditional IRA, that’s $3,000 of income the IRS won’t tax you on that year.
With a Roth IRA, you don’t get that same immediate tax break, since your account is funded with after-tax dollars. However, Roth IRA investments grow tax free, and withdrawals are tax free as well. With a traditional IRA, your gains are tax deferred, but you pay taxes on them when you take withdrawals, which are a taxable source of income in retirement.
Another benefit of saving in a Roth IRA is that you can technically withdraw your principal contributions at any time. With a traditional IRA, withdrawals taken before age 59 1/2 are subject to a 10% penalty with limited exceptions, like buying a first-time home. But because you don’t get a tax break on your principal Roth IRA contributions, the IRS doesn’t penalize you for taking that money out of your account before age 59 1/2.
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So here’s how that might work. Let’s say you contribute $15,000 to your Roth IRA and your balance grows to $25,000 because of your investments. As long as you don’t touch the $10,000 gains portion of your account prior to turning 59 1/2, there’s no penalty to worry about. But while you might appreciate this flexibility with your Roth IRA, you should know that it’s an option you should generally try to avoid at all costs.
The problem with raiding your Roth IRA
When you’ve worked hard to save for retirement, the last thing you want is to be penalized for taking out the money that’s yours. With a Roth IRA, that may not be an issue. But just because you can take an early withdrawal penalty free doesn’t mean that you should.
When you remove funds from a retirement account early, you have that much less money waiting for you once retirement begins. But you’re not just losing out on the principal amount you remove — you’re also forgoing potential gains.
Over the past 50 years, the stock market has averaged an annual 10% return. So let’s say your Roth IRA does similarly, and you take a $15,000 withdrawal at age 40 to buy yourself a used car.
You may not be penalized on that withdrawal as long as it comes from principal contributions only. But if you don’t retire until age 65, missing out on 25 years of gains on that $15,000 could actually leave you short about $162,500. That’s a lot of potential retirement income to give up.
Don’t turn your Roth IRA into your savings account or emergency fund
Because you can access Roth IRA funds penalty free before age 59 1/2, you may be inclined to tap that account when you need money. But if you treat your Roth IRA like your personal ATM, you’re going to negate the whole benefit of funding that account in the first place.
So don’t look at your Roth IRA as your backup savings account. You should have a separate emergency fund in the bank for unplanned bills.
Also, don’t tap your Roth IRA when you’re tempted to spend money on things you want. Instead, save up for them. Or if you really have to, find ways to borrow for them affordably. If you boost your credit score, you may be eligible for some relatively competitive rates on different loan products.
The whole purpose of funding a Roth IRA is to set yourself up for a secure retirement. So even though you can take money out penalty free ahead of time, remind yourself that every withdrawal you take puts you one step further away from that goal.
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