Build Up Savings Vs. Start a Roth IRA

You may be able to create a savings and snag a tax credit at the same time.

You may be able to create a savings and snag a tax credit at the same time.

There's always a conflict when you save money. On the one hand, if you build up your savings, you can have it available at any time you need it. On the other, contributing to a Roth IRA will give you tax-free growth for retirement and you might be able to get a tax credit if your income is below a specified amount. Making the best decision all depends on your situation.

Size

You need to have some easily accessible funds for emergencies. That's where a savings account is at its best. While some planners suggest that you keep at least 3 to 6 months of income in a high-yield savings, others believe the amount should be closer to 10 percent your annual income if you work a stable job for someone else, or increase that amount to 20 percent if you're self-employed. If your job is on shaky ground, go even higher.

Time Frame

The younger you are, the more benefit you'll reap from a Roth IRA. In a Roth, you don't pay taxes on the growth. The more time you have the money grow, the bigger the growth and the more you'll save in taxes. If you put $1,000 in a Roth when you are 50 and received a 6.5 percent return, you'd have $ 915.43 grow free of taxes by the time you hit 60. However, if you were 25 when you put it in, the tax-free growth would be $8,725.92, which is a huge difference.

Penalty

While it's tempting to put funds in because of the tax savings, if you don't have emergency funds or think you might need the money, you'll pay dearly. If you remove funds from the Roth before the age of 59 1/2, you'll pay not only the taxes on the growth, but also a 10 percent penalty. As of 2010, your income must be below $105,000 if you're single, or $167,000 if you're married filing jointly, to qualify for a Roth.

Solution

The good news is that you don't have to have it an all or nothing proposition. Set aside a small amount each month for your Roth IRA with a larger amount toward your savings until you build the amount of money necessary for emergency use. Simply tucking away $10 a week accumulates to $520 by the end of the year and is enough to start a Roth IRA without dramatically affecting the amount you save. As of 2010, if your income is less than $27,750 and you're single or married filing separately, or if your income is $41,625 and you're married filing jointly, you'll get a tax credit for the Roth deposit.

Considerations

If you put money into a Roth and receive a tax credit, but have to remove it within a year or two, you'll find the 10 to 50 percent tax credit gave you more benefit than the 10 percent penalty on growth costs. It's a win-win situation.

Warning

Before you invest in any product for your Roth, check for fees and minimums. Steer clear of the product if it has an annual fee. Some annual fees are large enough to wipe out any growth and may even dip into your principal.

About the Author

I've modeled, taught, raised and sold flowers and plants, was a stock-broker for 28 years, and had to quit due to health. I am quite goal oriented and have never missed a deadline in my life. I enjoy research into topics and am quite good at that aspect of the job. I love to insert humor into my articles, but follow the constraints of its purpose. I can write on almost anything. Home building and remodeling is one topic where I've been successful, but that is because I live with a remodeler. I am trained in music, psychology, and have a vast library on metaphysics and quantum physics. {{}}

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