Why is a ROTH IRA better than setting aside money in a savings account if I add post-tax dollars?
In: Economics
Very simple: when you withdraw from your Roth IRA in retirement, you do not pay taxes on the growth in the account.
Whenever your savings accounts earns interest, you pay taxes on that interest.
ROTH IRAs have tax advantages that a normal savings account doesn’t.
With a savings account, you pay tax on your income, put it in savings, and then pay tax on the interest every year as it accrues.
With a ROTH, you pay tax on your income, put it in the ROTH, and then never pay tax on that money again. Whenever you withdraw in retirement, whatever gains you have are tax-free. This can result in _considerable_ tax savings depending on how long you have the ROTH and what your tax rates are.
The disadvantage, of course, is that you can’t withdraw from a ROTH early without penalty – there are not additional penalties for withdrawing from savings.
Your IRA is going to earn at least double the amount of even the highest interest savings account. 10% is the general return compared to savings which are below 5%.
1. Earnings: investments have higher returns than savings. If you put $10,000 in savings this year and it earns 5% interest, it earns $500. If you buy $10,000 of stocks at $150/share, that gets you 66 shares. If those shares increase in value by $10, you will have earned $660 instead of $500.
2. Taxes: you will owe income tax at the end of the year on that $500 earned in the savings account. You will not own income tax on the $660 earned in the Roth IRA because that is a special kind of account where the government allows you to not pay income tax on the earnings.
3. Timing: because the Roth IRA is a retirement account with rules about how it can be used and how long the money has to stay in it, along with the protection from taxes, the money you put in it will stay there for many years and continue to grow. You may not be as likely to leave a sum of money sitting in your savings account for 20+ years. Once you get to that 20+ year point and start withdrawing the money, you probably will not have a job and will need to keep as much money as possible to pay your bills, so you benefit greatly by not having to give any of it to the government in the form of income tax.
For most people, this will not be an either/or choice. Both are tools to be used for specific financial goals. There is a limit to the amount of money you are allowed to put in a Roth IRA each year, and there are restrictions to whether or not you can even use one in the first place based on your income.
I have a savings account that I use for short term goals like my annual car insurance premium and vacations. I have a Roth IRA for retirement savings. I have other investment accounts that don’t have the same tax protections as the Roth IRA because I am limited on how much money I can put into the IRA, but I still want to earn more interest than I can get from a savings account.
It’s only better if you want to and are able to keep your money in it until you retire and withdraw then
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