Last month in a post about how much you should save for retirement, I talked about the factors you should use to decide how much to save for this stage of your life. Among those factors were: whether you receive an employer match, your own personal calculation for how much you’ll need, and professional recommendations on the subject.
A good recommendation many retirement planners make is that you’ll need at least 80 percent of your current income to live comfortably in retirement. So let’s say you’ve committed to saving a portion of your income for your future. What’s the best way to put that money aside and let it grow over the years?
One of the easiest, most effective ways to save for retirement is to open a Roth IRA. With a Roth, you don’t get an up-front tax break like you do with a regular IRA or 401(k). But every dollar you put into a Roth now is spent tax-free in retirement. Not only are your contributions tax-free, but your earnings are as well.
Roth IRAs are also great from a mental perspective. With a regular IRA, every dollar you put in now will be a lot less than that when you take it out. You’ll be taxed at future tax rates based on your total income during retirement. So that dollar might only be 70 cents, or even 65 cents. But with a Roth IRA, your dollar now is a dollar in the future. In this way, you can psych yourself into saving more for retirement.
Investing in a Roth is a great way to hedge against future income tax increases. At the rate our federal government has been borrowing, tax rates will very likely go up in the future. You can avoid paying higher taxes by paying them at today’s rates and letting your Roth grow tax-free. If you have a 401(k) through your employer, a Roth allows you to balance your tax burden between now and retirement.
Once you have established a Roth IRA, you can withdraw your contributions penalty-free at any time for any reason. You can also withdraw your earnings for certain reasons such as medical expenses greater than 7.5% of adjusted gross income, education expenses or a first-time home purchase (up to $10,000). In this way, a Roth can double as an emergency fund or a savings account, although I recommend setting aside a separate stash of money for these purposes. I even took out a little bit from our emergency fund to set up a Roth account for my wife, knowing that in a bind I could access the money.
A Roth IRA is like a house. In that house you must put furniture — the individual funds that will make up your investment mix. In the next post I’ll talk about one type of fund that’s grown tremendously in recent years, which is my choice to use for retirement savings.
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