Interest rates are low. Probably the lowest you’ve ever seen in your life time. This leaves a lot of people wondering how they can do better with their savings.
In fact, a friend was asking if a Roth IRA might be the answer. She was wondering how a Roth IRA differs from a savings account and if it might pay better interest. She wanted me to explain to her savings account vs Roth IRA.
We began our conversation by talking about savings accounts.
Savings accounts have three benefits:
1. First, because of FDIC insurance, your deposits are guaranteed up to $250,000. This means there is no chance you can lose your money.
2. The second benefit of a savings account is that there are no restrictions on how much money you can deposit. This is not true of all investments.
3. The third reason many people find savings accounts attractive is because they are completely liquid. This means you can withdraw your money any time you choose, without penalty.
These are three powerful reasons why savings accounts can be a useful tool in your investment tool kit.
Next, we talked about Roth IRAs. Roth IRAs have many unique benefits that are not available with savings accounts. Keep in mind, however, that with these benefits come some unique limitations.
1. The first benefit is that, if you follow certain rules, any interest or growth in the account will not be taxed. Not now and not when you make distributions. In fact, if you die and leave the Roth IRA to your children, they won't pay any tax either.
However, unlike a savings account, which has no limitation on when or how much money you can withdraw. Roth IRAs have specific rules that, if not followed, could result in taxes or penalties.
When you take money out, the contributions come out first. So long as you are only taking out contributions, there will be no restrictions, penalties, or taxes due.
But, if you remove all your contributions and begin dipping into the earnings, there are two other rules that come into play that will have negative consequences and could make your distributions more expensive.
The first has to do with timing. When did you initially fund your Roth IRA? Was it more than 5 years ago or less?
If it was less than 5 years, and you are removing earnings, you will be making a non-qualified distribution. This means, you will be subject to a 10% penalty. In addition to the penalty, you will also have to pay tax on non-qualified distributions.
Another factor that will affect the treatment of distributions from your Roth IRAs is your age. Are you younger than 59 ½ or older?
If you are older and began funding the Roth IRA more than 5 years ago, your distributions will be deemed qualified and you won't have to pay any tax or penalty.
If, however, you are younger than 59 ½, you should think carefully before removing earnings from your Roth IRA. In this instance, the distributions will be deemed non-qualified and as a result, you will be forced to pay a 10% penalty and tax on the distribution.
This can be expensive. For example, if you are in the 25% tax bracket, you would lose 35% of the distribution to taxes and penalties.
There are some exceptions to these rules, such as first-time home purchases and disability.
2. Roth IRAs have the added benefit that you have access to many more investment options than with a savings account. In fact, the whole world of investments is pretty well available.
With a Roth IRA, you can be very conservative and invest in CDs, short term bonds or money market accounts. Or you could be very aggressive and buy individual stocks, ETFs, or Mutual Funds. The choice is completely up to you.
Which is best?
In the end, my friend came to the conclusion that a Roth IRA wasn’t better than a savings account and that a savings account wasn’t better than a Roth IRA.
They were both good and useful tools but they served different purposes. Each of them could help you reach unique goals and objectives.
A savings account is a great place to park money that will be needed in the near future, giving you easy access and security of principal.
But if you have excess money that you want to put away for retirement, you'll probably do better with a Roth IRA.
The Roth IRA gives you tax free growth for the rest of your life. It also provides access to a wide range of investment options. It can even provide some liquidity by allowing your contributions to be removed without penalty at any time as long as you follow the rules. (For more on IRAs, read our 10 Biggest Rollover Blunders)
In the end, my friend could see that she had been asking the wrong question. A more useful question was, how can I use these tools to improve my financial situation?