This Roth IRA Benefit Could Be its Biggest Drawback
There are lots of great reasons to love Roth IRAs. Not only do they allow your assets to grow on a tax-deferred basis, but once you reach retirement, your withdrawals are tax-free. Furthermore, Roth IRAs don't impose required minimum distributions, so your money can sit and grow for as long as you'd like. In fact, the Roth IRA offers so many perks that my colleague Sean Williams has, on more than one occasion, dubbed it America's greatest retirement tool. But while the beauty of the Roth lies in its inherent flexibility, this particular feature can, inevitably, also wind up being its greatest drawback -- specifically, when it comes to early withdrawals.
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Early IRA distributions
Traditional IRAs are funded with pre-tax dollars, and so taking distributions prior to age 59-1/2 will result in a 10% early withdrawal penalty unless you qualify for an exception. And there are exceptions. For example, you can remove money early from a traditional IRA to pay for college without incurring a penalty. Similarly, you're allowed to withdraw up to $10,000 penalty-free for a first-time home purchase. But if you need the money because you want to, say, finish your basement, you're out of luck.
Roth IRAs work differently. Roth IRAs are funded with after-tax dollars, so the rules surrounding early withdrawals are far more lenient. In fact, you can actually withdraw your principal contributions to a Roth IRA at any time, for any reason whatsoever, without incurring a penalty. Now keep in mind that this provision applies to initial contributions only, not earnings. However, the IRS treats Roth IRA withdrawals as initially coming from contributions and then from earnings, so if you play your cards right, you could get at that money early without having to fork over a dime.
In fact, it's this rule that makes Roth IRAs so appealing to younger savers in particular. Many workers in their 20s or 30s have trouble getting behind the idea of locking up their money for 30 to 40 years or more, but since the Roth allows for early withdrawals, contributions become less risky. But while early penalty-free withdrawals may seem like a good option in theory, they're a dangerous one in practice.
A blessing and a curse
Though some people use Roth IRAs as a college savings tool, unless you open one specifically for this reason and have another retirement savings plan in place, the purpose of your Roth IRA should be to save for retirement. And if you withdraw money along the way when life's expenses catch up with you, you'll risk falling short when retirement eventually rolls around.
One thing to remember about early Roth IRA withdrawals is that you're not just losing out on whatever principal amount you've removed for retirement; you're also losing out on whatever growth that principal could've achieved. Imagine, for instance, that you remove $15,000 from a Roth IRA at age 40 to pay for, well, whatever it is you want to pay for. Let's also assume that the investments in your Roth generate an average annual 8% return over time. Over the course of 25 years, that $15,000 could've grown into roughly $103,000, which, over a 20-year retirement, would give you an extra $5,150 a year, or $429 a month, of income. Now that's a much bigger deal than losing out on just $15,000.
A Roth IRA is not an emergency fund
You may be tempted to tap your Roth IRA if an unplanned expense arises and you don't have the money on hand to cover it. But remember, your Roth IRA isn't designed for emergencies. Rather, it's meant for retirement -- otherwise known as the time in your life when you'll need that money the most. While you can access that money in a pinch, you're far better off designating a separate emergency fund to cover whatever short-term hiccups sneak up on you.
Most people need three to six months' worth of living expenses in an emergency fund for adequate coverage, and that money should be stored in an accessible savings account -- which brings up another point about Roth IRAs. If you're forced to withdraw money from your retirement savings to address an emergency and the timing happens to coincide with a market downturn, you risk an even greater financial loss.
Roth IRAs are an extremely valuable retirement savings tool, and there are plenty of good reasons to open one. But don't let the flexibility that comes with a Roth work against you. The money you put into a Roth will best serve its purpose if it's there for you in retirement, and until you reach that milestone, you're better off leaving it alone.
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