It won’t surprise many to find out that a tax-focused financial planner is fond of the Roth IRA. What might surprise you is that Coronavirus has caused me to reconsider the Roth IRA. It turns out that the Roth IRA is even better than I originally thought. We will get to that in short order. But first, a brief review of the advantages of a Roth IRA.
Tax Free Growth
Amounts in Roth IRAs grow tax free. Considering many Americans may now live into their 80s, 90s, and beyond, this is a tremendous benefit.
The only caveat is that in order for all distributions from Roth IRAs to be tax and penalty free, they generally have to be either (a) a return of contributions or of sufficiently aged conversions (see below), or (b) a distribution of earnings made in the Roth IRA (or other amounts in the Roth IRA) at a time when the owner of the account is 59 ½ or older and has owned a Roth IRA for at least five years.
The rules for ordering distributions out of a Roth IRA generally provide that contributions come out first, and then the oldest conversions come out next. This means that in many cases Roth IRA distributions, even those occurring before age 59 ½, are tax and penalty free.
N.B. Generally speaking, you want to only take a distribution from a Roth IRA before age 59 ½ if it is either (i) a serious emergency or (ii) part of a well crafted, very intentional financial plan.
Ease of Administration and Withdrawal
There are many financial institutions that provide Roth IRAs. Investment expenses in low-cost index funds at financial institutions that provide Roth IRAs are approaching zero. Vanguard, Fidelity, and Schwab are among the very good providers of low-cost Roth IRAs (and there are others).
It is also relatively easy to access money inside a Roth IRA. This makes the Roth IRA a great account to have in an emergency. Of course, it is generally best to leave money inside a Roth IRA to let it grow tax free, but it is good to know that you can access money in a Roth IRA relatively easily if an emergency arises.
Tax Free Withdrawals of Contributions
This is a great benefit of the Roth IRA. Contributions to a Roth IRA can be withdrawn at any time for any reason tax and penalty free. Further, the first money deemed distributed from a Roth IRA is a contribution. Here is a quick example:
Mark is 35 years old in 2025. He made $6,000 contributions to his Roth IRA in each of 2020, 2021, 2022, 2023, and 2024 (for $30,000 total). In 2025, when his Roth IRA is worth $41,000, Mark withdraws $10,000 from his Roth IRA in 2025. All $10,000 will be deemed to be a return of contributions, and thus entirely tax free and penalty free.
The only exception is a taxpayer favorable exception: a timely withdrawal of an excess contribution (and related earnings) occurs before regular contributions are considered withdrawn.
N.B. Roth 401(k)s, 403(b)s, and 457s have different distribution rules — most pre-age 59 ½ distributions will take out some taxable earnings.
Tax Free Withdrawals of Sufficiently Aged Converted Amounts
If you convert an amount into a Roth IRA, you start a five year clock as of January 1st of the year of the conversion. Quick example:
Mike is 35 years old in 2020. Mike converts $10,000 from a traditional IRA to a Roth IRA on July 2, 2020. His five year conversion clock starts January 1, 2020. On January 1, 2025, Mike can withdraw the entire $10,000 he converted in 2020 tax and penalty free.
This feature of the Roth IRA, the tax free withdrawal of sufficiently aged conversions, is the basis for the Roth Conversion Ladder strategy. Sufficiently aged converted amounts are deemed to come out after contributions are exhausted and before more recent conversions and earnings come out.
No Required Minimum Distributions
During an account holder’s lifetime, there are no required minimum distributions from a Roth IRA. You can live to 150 and never be required to take money from a Roth IRA. Other than an HSA, no other retirement account has this feature!
N.B. Roth 401(k)s, 403(b)s, and 457s have required minimum distributions.
Creditor Protection
In federal bankruptcy proceedings, Roth IRAs are (as of 2020), protected up to $1,362,800.
Where there can be differences in liability protection are state general creditor claims (i.e., creditor protection in non-bankruptcy situations). In some states, Roth IRAs receive a level of creditor protection similar to that of ERISA plans. Generally, such protection is absolute against all creditors except for an ex-spouse or the IRS.
In other states, Roth IRAs receive no or limited creditor protection. In my home state of California, Roth IRAs are only creditor protected up to the amount necessary to provide for you and your dependents in your retirement (as determined by the court). Such protection is valuable but hardly airtight.
A Sneaky Way to Contribute More to Your Retirement
Yes, in theory everyone should save for retirement based on exacting calculations (i.e., I estimate I need $X in retirement, so based on projections I save $A in traditional accounts and $B in Roth accounts this year). That’s the theory.
In practice, it’s “I maxed out this account and that account” or “I put $C into this account and $D into that account.” There isn’t that much wrong with how we practically save for retirement, as long as we are saving sufficient amounts for retirement.
But not all “maxing out” is created equal. We know this because if Jane has $100,000 in a traditional IRA and Mary has $100,000 in a Roth IRA, who has more wealth? Mary! Unless Jane can always be in a zero percent income tax bracket, Mary has more than Jane, even though they both nominally have $100,000.
A Great Account to Leave to Heirs
While non-spouse heirs will have to take taxable required distributions from inherited IRAs (in many cases beginning in 2020 they will need to drain the account within 10 years of death), heirs are never taxed on distributions from Roth IRAs. This makes a Roth IRA a great account to leave to your heirs.
Compare with Other Retirement Accounts
No other retirement account combines ease of administration and withdrawal, low costs, significant tax benefits, creditor protection, and great emergency access the way the Roth IRA does. Most workplace retirement plans have some restrictions on withdrawals. Traditional account withdrawals do not have the tax advantages of a Roth IRA. Distributions from a traditional IRA, even one at a low-cost, easy to use discount brokerage, will trigger ordinary income taxes, and possible penalties, if withdrawn for emergency use.
Financial Planning Objectives
Personal finance is indeed personal. But I submit the following: pretty much every individual has some desire (and/or need) to not work at some point in his/her lifetime and every individual needs to be prepared for emergencies. Further, these are two very important financial planning objectives for most, if not all, individuals.
If the above is true, then we must ask “which account type best supports the combination of these two pressing financial planning objectives?” It appears to me that the answer is clearly the Roth IRA.
None of this is to say that a Roth IRA is the only way to plan for retirement and plan for emergencies, but rather, it is to say that, generally speaking, a Roth IRA ought to be a material element in such planning. Other tools, such as other retirement accounts, insurances, investments in taxable accounts, and sufficiently funded emergency funds are likely needed in addition to a Roth IRA.
Retirement Accounts and Emergencies
Let’s examine how a Roth IRA might help someone facing a very serious emergency.
Picture Jack, who is 52 years old, and has a full time job. He has $1M in a traditional 401(k) and $10,000 in cash in a taxable account. That’s it. Then picture Chuck, also 52 with a full time job. Chuck has $700,000 in a traditional 401(k), $250,000 in a Roth IRA, and $10,000 in cash.
Who is better situated to deal with an emergency? Far and away the answer is Chuck. 401(k)s are difficult to access in an emergency. First of all, the 401(k) plan might not allow in-service distributions, and it might not allow taking out a loan.
Even if the 401(k) allows in-service distributions, distributions from 401(k)s are immediately taxable, and often subject to penalties (10% federal, 2.5% in California, for example) if you are under age 59 ½. Loans, while not immediately taxable, can become taxable if not paid back.
Long story short, a 401(k) may be a tough nut to crack in an emergency.
What about a Roth IRA? In Chuck’s case, he can access his prior Roth IRA contributions and sufficiently aged contributions tax and penalty free at any time for any reason! And his Roth IRA is easy to access, particularly if it is at a low-cost discount brokerage.
Not all emergencies will look exactly like the Coronavirus emergency, and many of them will be individual emergencies, not global pandemics. The best, most accessible type of tax advantaged retirement account for an emergency is generally a Roth IRA. And it may be the case that your emergency fund is not sufficient to tide you over, so having that Roth IRA backup can be very valuable.
When you combine tax-free growth, no requirement to take required minimum distributions during the account holder’s lifetime, and the best emergency access of any tax-advantaged retirement account, it is difficult to see why working adults should not have at least some money in a Roth IRA.
When a Roth IRA Doesn’t Make Sense
The short answer is: not often! I struggle to come up with profiles of individuals that would not benefit from having some amount in a Roth IRA.
I can think of two profiles. The first, a rare case, is someone with very large legal liabilities such that all of their wealth would benefit from the creditor protections offered by an ERISA retirement plan (such as a 401(k)) and who needs almost all of their wealth shielded from creditors.
First, if you have built up 6 figures or more in wealth, having creditors able to claim your entire wealth is relatively rare. Second, in most cases, good insurance coverage, including adequate medical insurance, professional liability insurance (as applicable), home and automobile insurance, and personal umbrella liability insurance, should protect the vast majority of people such that they could withstand any liability exposure caused by having money in a Roth IRA instead of an ERISA protected plan.
The second profile is someone with incredibly high income currently and very little anticipated income in the future (such that their future tax rate is much lower than today’s rate). This too is a bit of a unicorn – people with high income today tend to have high income tomorrow (even in the FI community). And even if you anticipate being in a lower tax bracket tomorrow than you are today (a) that is simply a guess (we don’t know what future tax rates will be) and (b) you still benefit from the emergency access and years of tax free growth that a Roth IRA provides.
Health Savings Accounts
It will also come as no surprise that I am fond of health savings accounts. Health savings accounts share some of the attributes that make the Roth IRA such a winner for both retirement savings and emergency planning.
But, there are some drawbacks. First, the distribution ordering rules are not as taxpayer friendly. While it may be the case that you have sufficient old medical expenses that you can reimburse yourself for (and thus not pay tax and a penalty on the HSA distribution), that is not always going to be the case, and even if it is, does add a layer of complexity.
Second, the HSA is not for everyone. If a high deductible health plan is not good medical insurance for you, an HSA is generally off the table.
So, that leaves the HSA as a fantastic option for those who qualify for and use a high deductible health plan (and usually an option that should be part of a comprehensive financial plan if you use a HDHP). But it also means that the HSA is not quite as good as a tool for the combination of retirement saving and emergency planning.
Conclusion
Assuming that an individual (a) has retirement planning and emergency preparedness as financial planning objectives and (b) is not in a position where legal liabilities would cripple them without ERISA creditor protection, it is hard to argue against having at least some material amount in a Roth IRA.
Every American working adult should ask whether they have a Roth IRA, and if they do not have one, they should ask why that is. All working adults should strongly consider a Roth IRA contribution, a Backdoor Roth IRA, and/or a Roth conversion in 2020.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
I love your posts! Quick question: What about those in the FI community that are interested in retiring early or planning to have lower income later in their working career? If they contribute to a Traditional IRA during their working years and then retire to much lower income, they can do an IRA conversion ladder and slowly convert their tax-deferred money into tax-free money and can withdraw those contributions free and clear after five years. So, isn’t contributing to a Traditional IRA just as good for those in that particular case?
Kwame, thank you for reading the blog and commenting. I appreciate it!
Here’s my take (which, of course, is not advice for any particular taxpayer): play it out during the working years. Mr. Smith has an emergency come up in his life while he is working before age 59 1/2. He exhausts his emergency fund, and now he needs to tap into a retirement account. If all he has is a traditional IRA, he is looking at taxable ordinary income and a possible 10% penalty (just because he has an emergency does not mean it will qualify for a penalty exception under the tax rules).
So, where does that leave Mr. Smith? Could the long term Roth Conversion Ladder strategy work? Sure, it could. But I believe also having at least some of Mr. Smith’s portfolio in a Roth IRA while he is working helps meet both financial planning objectives – retirement planning and emergency preparedness.
I was under the impression that you had to have the Roth established for 5 years before you can access the original contributions (not a conversion). It sounds like I might have misunderstood this? Thanks again for another informative article.
Jeff, thank you for reading and commenting, I appreciate it.
There are two Roth IRA 5 year rules. One applies to Roth conversions if you are under age 59 1/2 – you cannot withdraw taxable conversions penalty-free unless the conversion is 5 years old or older (as determined by the tax rules). The other 5 year rule applies to earnings inside a Roth IRA – you cannot withdraw the earnings of a Roth IRA in a qualified distribution (which is tax-free) unless you have had a Roth IRA for at least 5 years.
Roth IRA contributions, on the other hand, are subject to neither 5 year rule. And since contributions are deemed to come out first when taking distributions (again, PLEASE PROCEED WITH SIGNIFICANT CAUTION PRIOR TO TAKING AN EARLY DISTRIBUTION), if a taxpayer has significant previous Roth IRA contributions, he or she will need to make significant withdrawals before potentially bumping up against one of the 5 year rules.
Just to clarify, are you saying that you can withdraw earnings if you have had a Roth IRA for more than 5 years? Are you not subject to taxes, but to the 10% penalty?
Kwame, the 5 year rule is only one of several rules one needs to navigate in order to withdraw earnings from a Roth IRA both tax and penalty free. A taxpayer could have a Roth IRA from age 1 and if they withdraw earnings from their Roth IRA at age 58, they will pay tax and the 10 percent penalty as a general rule (even though they did satisfy the 5 year rule).
They *might* qualify for a penalty exception (which would require its own analysis), but as a general rule they will be subject to both ordinary income tax and a penalty on such a withdrawal of earnings at age 58, even though they did successfully navigate the 5 year rule.
Thank you for the detailed clarification, a coworker of mine was weighing putting additional money in a Roth 401k (above and beyond the match) or putting the excess in a Roth IRA so I sent him this article. I wanted to clarify the 5 year requirement once he asked me the question.