Friday, February 28, 2014

Another Problem with the Roth IRA (Cookie-Cutter Solutions)

What works for one person might not work for others.   Financial advice is not generic, but specific to each person's situation.   Do the math on your own situation before adopting someone else's advice.

In an earlier post, I mentioned that converting to or starting a Roth IRA might not make sense.  Financial advisers tout how great the Roth IRA is, and many people go out and open them, without really understanding why they are better or worse than a traditional IRA.

In a very recent post, I mentioned that I did the taxes for some friends of mine, who between disbursements from their regular IRA and Social Security, made $44,000 a year and paid no taxes.  That's right, no taxes, neither Federal or State!

I also recently read, on the "Mr. Money Mustache" site, about a young man who is putting all of his retirement savings into a Roth IRA.

While his savings rate (15%) is commendable, I question whether he should think about starting a regular IRA as well, rather than put all your eggs in one tax basket.

You see, in a Roth IRA, you pay taxes on the money going in, but no taxes on the money coming out.   This can be handy, if you make a lot of money and want to live a rich retirement, tax-free.   It also means if you want to retire early, you can take out money tax-free.

BUT, for ordinary retirement, he may end up paying little or no taxes anyway, and in such a scenario, he is missing the boat - paying taxes at the highest rates (while earning) and avoiding non-existent taxes in retirement.

So what's the answer?   There is no answer.

You have to crank the numbers and do the math for your particular scenario.  Cut-and-paste answers don't always work.  What works for me, might not work for you, and vice-versa.

For example, this same young man was wondering whether to pay off his mortgage, and someone cited my experience as an example.

The problem is, my experience was that of a 50-year-old facing early retirement, with a 30-year 5% mortgage with a $3000 a month payment - and plenty of retirement savings.   For me, it made sense to take a tax-free lump sum payout from the sale of my vacation home and pay off my mortgage.  Going into retirement with a huge monthly nut to crack, made no sense at all.

For him, a different story.   He is 30, has a low mortgage payment with a small balance (compared to the market value) on a 15-year note at less than 4%.    He has time to pay off this note before he retires, the balance and the payment are not a substantial burden, and he should concentrate on building up savings, as well as paying down debt.

TIME - that is the key.   For him, compound interest is a friend.  Contributing to savings has a snowball effect.   For me, a dollar I put into savings today might be a  $1.25 in retirement, factoring inflation into the mix.   My needs at age 54 (now) are far different from that of someone at age 30.  I'm already a millionaire.  I don't need to "save up for retirement" anymore - just coast until age 59.

What worked well for me (eliminating about $20,000 a year in interest payments, that would have killed me in retirement) would probably be silly for him, particularly since his mortgage payment is so much lower than mine - and since he makes more money (at $75,000 a year) than I do.  In fact, he would benefit from tax deductions far more than I would.

Get a calculator, and use it.  Figure out what works best for YOU.

But do the math.  Don't just adopt off-the-shelf solutions.