ROTHs seem to be highly touted

behaviorkeltonMay 20, 2008

Whenever I read a retirement article, there seems to be strong leaning toward ROTH plans rather than 401k or 403b if those plans offer no employer matching.

I just read, also, that ROTHs allow for penalty free withdrawals if you lose your job or some other urgency.

The 401k style plans would require big penalties.

So am I getting this right? ROTHs are the way to go?

I like the idea of a retirement account that can serve as an emergency fund as well. With that, I would feel better about contributing more aggressively instead of keeping it back in a regular bank account for big emergencies.

You can only contribute $5,000 a year. That's one downside.


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I have a Roth, this is because I had to transfer my 401k into an IRA when my company left town and I didn't have any retirement accounts that I could then even contribute into at that point. I don't think I would have even thought about one if I didn't need to transfer my 401k.

I like the idea of having numerous types of accounts. Right now I have a Roth, traditional IRA and 403b.

IRA's are taxed differently so they have their downsides. You put in after tax money, while 401k and 403b's are before tax money, so you notice it less when you take money out of your paycheck for the 401k and 403b's. They are also taxed differently when you take your money out.

Also, only being able to contribute 5000 can be a HUGE downside for some people, which why having multiple accounts my help.

My retirement accounts are NOT ever to be touched so I never even really think about withdrawing from them. I build up a savings at the same time as my retirement accounts so I have a savings for emergencies.

Also, the company may not match your 401k but it may manage it for free, which can save you some money each month.

I think if I were starting over I would consider having both a 401k (or 403b) and IRA again, just because one is before and one is after tax. It is much easier to make before tax contributions.

    Bookmark   May 21, 2008 at 8:43AM
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Scryn's posting makes some good points. Another advantage to having both types of retirement accts is that people occasionally want to throw extra after-tax money into a retirement account. Having only a 401k can create a nightmare of paperwork when people don't realize that it is up to the owners of the acct to prove to the IRS which part of the 401 is after-tax and which is before-tax. No broker or planner keeps such records nor has the liability for this. An elderly client at my former job got into trouble this way because he wrongly assumed the broker would keep the records for him.

You can remove the original contributions to a Roth without penalty, but then you are defeating the entire purpose of compounding. A Roth IRA, like any other retirement account, shouldn't be touched if at all possible.

It's generally assumed for actuarial purposes that because a Roth is funded with after-tax money, unless you are at least 15-20 years from taking the money out, your ROI will be less than using a pre-tax retirement account.

One of the best uses for a Roth is for inheritance. A Roth is not required to have Required Minimum Distributions as a pre-tax IRA does; e.g., a regular IRA must start distributions no later than age 70-1/2. Thus, inheriting a Roth with its compounded tax-free return is an incredible bonus to any heirs.

The other disadvantage is that you must have earned income to qualify for contributing to a Roth. If you are a SAHM, for instance, or retired on Social Security, you won't qualify for any Roth contributions.

    Bookmark   May 21, 2008 at 11:26AM
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You have to have earned income to qualify for any type of IRA, Roth or traditional.

A SAHM can qualify for a spousal IRA if their spouse works and the couple meet the other qualifications such as income and age.

    Bookmark   May 21, 2008 at 12:50PM
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I understand that tapping into one's retirement is a bad idea, but I'd prefer having options.

My girlfriend, at one point, borrowed money from her retirement company (ING?), and she borrowed a good portion of it for a very good interest rate....and this was a 403b. She used it to pay off all of her other debts bringing them into one simple loan.

Vanguard (my company) doesn't allow that, but I thought that it was pretty cool that a person could take a loan on their retirement rather than tapping directly into the retirement account itself.

Sidenote: She was into a healthy bit of debt when I met her, but now she is well into the black.

    Bookmark   May 22, 2008 at 8:19AM
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Black is beautiful, they say.

I agree.

ole joyful

    Bookmark   May 22, 2008 at 6:44PM
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It's generally assumed for actuarial purposes that because a Roth is funded with after-tax money, unless you are at least 15-20 years from taking the money out, your ROI will be less than using a pre-tax retirement account.

I've kind of wondered about the ROTH thing too. In 9 years, barring no accidents or health incidents, I hope to retire. Most of my retirement will come from what I think is akin to a traditional 401K through work (govt TSP). Since I'm closer than 15-20 years to retirement I was told don't contribute to a ROTH. But.......doesn't all that mean is - don't use your ROTH for retirement for 15 years? I.e. I could contribute for the next few years, retire, use my other assets, then start using the Roth LATER. Is there something wrong with that scenario?

    Bookmark   May 23, 2008 at 8:46AM
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Mary, whoever told you that didn't know what they were talking about. Assuming you were hired after 1983, you already have an old-style defined benefit pension with FERS, plus the government's version of a 401(k) with matching contributions in the Thrift Savings Plan, plus Social Security. You're not eligible to make deductible contributions into an IRA, so there is absolutely no better place for additional retirement savings than into a ROTH IRA.

    Bookmark   May 23, 2008 at 9:52AM
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There's nothing wrong with Mary's scenario of contributing for a few years and then leaving the Roth to compound. The only issue is that with the limit of $5K on Roth's, she won't really have much accumulated, so it depends on exactly how long she does have until retirement. My DH has less than 3 years, for instance (LOL - he was supposed to retire this year!), so for us maximizing the pre-tax contributions are better than establishing a Roth.

Remember that there is a "catch-up" provision for the over 50 crowd so for 3 years prior to retirement you can contribute $5K/yr extra ABOVE the already generous 401k limits. That's $20,500/yr pre-tax, which means it has a big advantage over the $5K limit on a Roth.

    Bookmark   May 23, 2008 at 10:52AM
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jkom, I agree with maximizing the 401(k), but why does it have to be an either/or scenario? Maximize the 401(K) AND THEN open up a ROTH. Since Mary mentioned that she was already contributing to the TSP, I assumed she was putting the maximum amount in and was looking for further advice on how to invest additional money toward retirement.

And on a side note, as long as we are talking about catch-up contributions for 401(k)'s, I might as well point out that the ROTH limit has been raised to $6,000 in 2008 for those age 50 and older.

    Bookmark   May 23, 2008 at 11:20AM
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jkom51, question -- you said:
"for 3 years prior to retirement you can contribute $5K/yr extra ABOVE the already generous 401k limits."

Are you saying one can only do the catch-up contribution for three years? I thought you could do it in every year after you turn 50 until you retire (or until they change the rule).

    Bookmark   May 23, 2008 at 12:02PM
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>>Are you saying one can only do the catch-up contribution for three years? I thought you could do it in every year after you turn 50 until you retire (or until they change the rule). Apparently it depends upon the employer and the plan. They CAN allow catch-up contributions but do not have to do so. At my husband's employer, they limit catch-up to 3 years prior to retirement.

    Bookmark   May 23, 2008 at 1:59PM
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"My girlfriend, at one point, borrowed money from her retirement company (ING?), and she borrowed a good portion of it for a very good interest rate....and this was a 403b. She used it to pay off all of her other debts bringing them into one simple loan."
This is generally a Bad Idea. Most employers will allows loan from your 401K/403b, but you lose the compounding benefit of having retirement money in an account. In addition employers who allow this will require immediate repayment of all outstanding "loan" at severance--meaning repay in full when you leave/lost the job -or- pay 10% tax penalty PLUS regular taxes as an "early withdrawal". Glad to hear she's living within her means now.

Can't speak to the OP's specific issues really, but... general advice for savings/retirement is below (in order). Mind you, I'm a 41-yr old single mom RN who will be able to retire comfortably in 11 years, but NOT any kind of pro. Your situation may be quite different, but this seems to work for me:
1. Pay yourself first (accessible savings for emergencies-- that you really only use for emergencies--I keep 6 months of expenses saved). If you do direct deposit, just stash $50 or $100 each paycheck into savings before it hits your checking acct.
2. Next, maximize your pre-tax retirement savings via 401K/403b--some employers "match" at least a few percentage points of what you contribute. Free money! Also, since it is pre-tax, you really don't notice the difference if you inch up the percentage of saving gradually-- most companies allow you to do this on-line now.
3. Then, some regular savings $$$. Non-retirement $$$--for vacations, Xmas, paying for all those health care premiums from retirement until Medicare). My credit union actually had a 4.25% 6 month CD with a minimum of $1K about 4 months ago!--hard to find these days, and not currently offered.) I put quite a bit of my non-emergency savings into that. Saving account/CD rates are really lousy right now.
4. Contribute to a Roth IRA-- and leave it there until retirement.
5. Save for kids' college (yes, last). There are loans and scholarships, and I'm looking out for #1 (me!) first. I do not plan to access my retirement dollars to pay for my daughter's college if at ALL possible. All child support $$$ (he's way in arrears, though, and I'm not holding my breath) goes into this.

    Bookmark   May 30, 2008 at 5:00PM
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Roth IRAS and 401Ks are especially good for younger people who are presently in a low income tax bracket. The federal income tax deductions that come with traditional IRAs and 401kS aren't as valuable to someone like that as they are to taxpayers in higher brackets. Yet, retirement is many years away. During those years, the Roth investments can grow, and there will be no income tax to pay on the withdrawals when the account owner finally retires.

For people who are closer to retirement and expect their tax bracket to drop when they retire, the tax deductions they get with the traditional IRAs and 401Ks usually make them the better choice.

    Bookmark   June 2, 2008 at 1:54PM
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You can also convert a traditional IRA to a Roth, but there are some tricky restrictions to doing this, some of which involve tax rules scheduled to change up to and through 2010.

I don't normally like to post an entire article from the WSJournal. But this particular question posed to their ENCORE section (which specifically deals with retirement and financial questions) might be of specific interest to some folks considering Roth conversions.

Contribution Methods Sway Roth Withdrawal Rules
May 31, 2008; WSJournal Encore section

Q: We couldn't contribute to our Roth IRA this year because of the income limits. I noted that we could contribute to a nondeductible IRA and then later convert it to a Roth, assuming we are under the $100,000 income limit or wait until 2010.

My question: Since we already have the Roth accounts open, am I right in assuming there is no five-year waiting period to make penalty-free withdrawals? Also, am I right in assuming that you can convert a nondeductible IRA into an existing Roth IRA?

--B. from Virginia.

The way the five-year waiting period works depends on the way you're putting money into a Roth individual retirement account. There's one set of rules for making penalty-free withdrawals if you are contributing to a Roth IRA, and another set for Roth IRA conversions.

Roth IRAs are attractive because they have no withdrawal requirements for the account's owner, along with no tax on future earnings on their assets, unlike traditional IRAs. As you note, there are income limits for making Roth IRA contributions. For 2008, your income must fall below $101,000 for an individual or $159,000 for couples filing jointly. If your income exceeds those limits, though, you may still be able to make a partial contribution (described in Publication 590 at www.irs.gov1).

There are no income limits for contributions to a nondeductible, traditional IRA, which you could convert to a Roth later. (One note: If you have pretax money in any IRA, you would owe some income tax on the conversion. Publication 590 explains how to do the math.) This year and next, you can convert a traditional IRA to a Roth if your modified adjusted gross income is no more than $100,000 a year, either for an individual or married couple filing jointly. Modified adjusted gross income is essentially all of your income except for that from any Roth IRA conversions and a few other exceptions. Publication 590 includes a work sheet explaining how to calculate this amount, along with more about what does and doesn't count toward modified adjusted gross income.

Starting in 2010, there are no income limits for Roth conversions. And in 2010 only, you can spread the income and accompanying tax from a Roth conversion across 2011 and 2012.

Once you've socked away money in a Roth IRA, either through a regular contribution or by converting other IRA assets, when can you take the money out without a penalty? You can withdraw your original contributions at any time with no penalty -- an advantage that a lot of people don't realize. But there is a five-year waiting period for withdrawals of any earnings. The five-year clock for earnings on regular contributions starts the year you open your first Roth IRA, and it doesn't reset each time you make a contribution. You also have to turn 59 years old to avoid a 10% penalty for early withdrawals on any earnings, along with income tax.

There's a separate five-year clock for assets you convert to a Roth account from other retirement accounts, says Ed Slott, an IRA consultant in Rockville Centre, N.Y. You have to hold those specific assets in a Roth for five years or until you turn 59½, whichever comes first, to make penalty-free withdrawals.

Why the separate five-year waiting period? The federal government wants to make sure Roth conversions aren't used as a penalty-free way to raid traditional IRAs early, Mr. Slott says.

    Bookmark   June 2, 2008 at 8:51PM
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Marys1000 says the following:

"It's generally assumed for actuarial purposes that because a Roth is funded with after-tax money, unless you are at least 15-20 years from taking the money out, your ROI will be less than using a pre-tax retirement account."

This statement is simply not true. Whether a Roth or a traditional IRA is more valuable depends on one thing and one thing only: Whether your marginal tax rate is higher when you put the money in (in which case a traditional IRA is better) or when you take the money out (in which case a Roth IRA is better).

In other words, imagine that tax rates remain constant at 25%, and that you put $10,000 into a traditional IRA. After some period of time, that money has quadrupled to $40,000. You withdraw it, pay 25% tax, and are left with $30,000.

Now suppose you had paid taxes on that money immediately and put it in a Roth IRA. You would have $7,500. That $7,500 would quadruple over the same period of time, so you would have $30,000 at the end of the period. It's a wash.

That said, there is one reason to prefer a Roth IRA even if tax rates don't change, and that is that the maximum amount you can deposit in an IRA is the same for traditional and Roth IRAs. But the amount is after taxes for Roth and before taxes for traditional IRAs, so you can effectively put more money into a Roth each year than you can into a traditional IRA.

    Bookmark   June 3, 2008 at 9:13AM
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Actually, alphacat, I believe I was the one who made that statement, not mary. Thank you for the interesting illustration you showed.

However, people who have significant IRA accts should still carefully consider whether conversion works for them or not. The linked article below has a very reasoned and thoughtful article on the subject.

IOW, conversions for older folks are extremely useful if you plan to never use your IRA money and want to pass it to your heirs who can continue to leave it alone to compound. If you plan to retire early and must immediately access your IRA for living expenses, after-tax compounding may not work in your favor.

I think all workers under 50 should be contributing to Roth IRAs. For those soon to retire, however, conversions require running some individualized tax scenarios that are beyond the scope of simplistic analyses.

    Bookmark   June 3, 2008 at 11:39AM
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