I remember when I got my first job out of college, and my starting salary was $30,000. I felt rich! It was the first time in my life that I wasn’t earning an hourly paycheck. But, it was also the first time in my life that I was responsible for all of my own living expenses—rent, car payment, car insurance, groceries, taxes… After federal and state tax withholding, what I thought of as my fat paycheck, was stretched to its limits.
I was fortunate to have the upbringing that I did, where discipline, saving, and frugality were traits that were drilled into me from birth. So, I knew that saving was important and I had to do something even though the funds I had were limited. The company that I was working for offered a 401(k) with a Roth option which ended up being a great choice for me when my income was at its starting point.
When it comes to retirement savings the mantra has long been “Seize the power of tax-deferred savings!” This is a very true statement. Tax-deferred savings can help you build a significant amount toward your retirement. However, even though the power of tax-deferred saving is impactful, when I was entering the workforce, and starting to establish my savings base, a Roth option made sense because I was in a relatively low income tax bracket.
Because I was in a low tax bracket, the benefit of an upfront tax-break in the form of tax-deferral was not as great as it became in later years, when income was higher and I was in a higher tax bracket. The advantage of saving post-tax money in a Roth when you are in a low tax bracket is that those funds can be withdrawn tax-free in retirement, or for other qualified reasons if Roth rules and requirements are met.
Now, if your employer offers a tax-deferred qualified retirement savings plan with a company match, it’s always in your best interest to contribute to the plan to take advantage of that match. There are few better deals than free money.
But, if yours is the only money going into an account, you may want to use your early savings years to make post-tax contributions to a Roth IRA or your Roth 401(k)/403(b)/457(b) plan. Since the money you are putting into your Roth is a post-tax contribution, you will not pay taxes when you withdraw the money. So, if you are in a higher tax-bracket in your later years when you want to access these savings, you will essentially have gotten a discount on what you pay in taxes.
Qualified distributions from Roth IRAs are tax and penalty free. In order for a distribution to be qualified, the Roth must be established and funded for at least 5 years and the distribution must meet one of the following conditions:
- Roth IRA holder must be aged 59½
- The distributed amount will be used toward the purchase or to build a first home for the Roth IRA holder or a qualified family member. There is a lifetime limit of $10,000 for this purpose.
- The distribution takes place after the Roth IRA holder becomes disabled
- The assets are distributed to the beneficiary of the Roth IRA holder after death.
Non-qualified distributions of earnings (distributions made prior to the 5 years anniversary of the establishment and funding of the Roth IRA and/or not meeting at least one of the conditions listed above) are subject to tax and early withdrawal penalty. However, your contributions to a Roth can be withdrawn at any time without penalty. Just realize that if you withdraw principal, that principal will no longer be taking advantage of the tax-free growth in the Roth.
Remember, the only successful road to retirement income is consistent saving with annual increases. Whether you choose post-tax savings in a Roth IRA or pre-tax savings with a tax-deferred savings plan, make sure you choose to save as much as you can, as soon as you can.
To learn more about IRAs, click here.
¹Average American Household Income from 2014 U.S. Census Bureau Labor statistics.
Depending upon state law, Roth IRA distributions may be subject to state taxes. This information is not intended as tax or legal advice. For advice concerning your own situation, please consult with your appropriate professional advisor.