By Ashlea Ebeling (Forbes Staff)
Original post date: 3/03/2014
During a visit to a Pennsylvania steel plant recently President Obama touted the flexibility that his gimmicky new myRA account provides young workers just starting to save. “In an emergency you can withdraw contributions without paying a penalty. So it’s a pretty good deal.”
Fact is, myRA is just a Roth individual retirement account with training wheels; the full, grown-up version is an ideal savings vehicle for millennials, including well-paid ones who also have a 401(k).
A Roth IRA has two main advantages for younger folks. Money you contribute to an old-fashioned, pretax IRA or 401(k) isn’t taxed now, but all withdrawals in retirement are taxed at high ordinary income rates. Roth IRAs work in reverse: You get no tax deduction for your contribution, but withdrawals after age 59 are tax free. By then your income should be higher, in real dollars, than at, say, 25, so your tax rate is likely to be higher, too, making the back-end tax break more valuable than the front-end one. A Roth could also shield you from a growing list of tax and benefit penalties on higher-income retirees.
The second big selling point for a Roth IRA is flexibility. Retirement is decades away and you might need cash sooner–to start a business, pay the rent while you return to school or, as Obama suggested, for an emergency. Take money out of a pretax IRA or 401(k) before retirement and you can get hit with a 10% early withdrawal penalty, as well as ordinary income taxes. (There are ways you might be able to avoid the penalty, but an estimated 5.7 million folks still got stuck paying it in 2011.)
By contrast, you can withdraw your original contributions from a Roth IRA without taxes, penalty or jumping through hoops. “Life is unpredictable,” says Dan Keady, a financial planner in TIAA-CREF’s advice strategy group. “The idea of having that money there in a Roth IRA that you can just pull is a big advantage for people.”
Wait a minute, isn’t a 401(k) the best place to start saving? Yes, usually, provided you’re offered an employer match–in the most common matches, your employer kicks in 50 cents or $1 for each $1 you save, up to maybe 6% of your salary. But if you’re planning a decent retirement and saving for other goals, too, you’ll need to sock away a lot more than 6% a year. So put enough into your 401(k) to snag the full match and then fund a Roth IRA.
For 2014 you can contribute $5,500 per person to a Roth IRA, provided your adjusted gross income isn’t more than $114,000 for a single or $181,000 for a couple. Above that the allowed Roth contribution shrinks and then disappears. Not to worry: If you earn too much, you can get around the restriction with a little fancy footwork (and paperwork). Put $5,500 in a nondeductible IRA and then convert it to a Roth IRA.
Fortunately, you have until Apr. 15 to fund an IRA for calendar 2013. If you don’t have the cash but expect to soon–say you’ve just started a high-paying job–hit your parents up for a short-term loan to make the contribution. Another option: If you file your 1040 early enough, you can ask the Internal Revenue Service to deposit your refund into a 2013 IRA.
What if you are already snagging the match in your 401(k) and fully funding a Roth IRA, and can save still more? Build an emergency account (three to six months of expenses) outside the Roth IRA, so you can leave the Roth untouched, growing tax free.
Once you have an emergency cache, consider maxing out your 401(k)–you can contribute up to $17,500 for 2014. Keep in mind, however, that your pre-retirement access to 401(k) funds is limited, particularly if you stay with the same employer.
A growing number of 401(k) plans give workers the option of directing some or all of their contributions into a Roth 401(k) subaccount. If yours does, consider using it, particularly if you expect your income and tax rate to rise. By law all employer contributions are made pretax, so by using the Roth you’re spreading your tax bets.