November 24, 2010

Is a Roth IRA the Right Choice for the Ms Davis?

Ms. Davis is a single woman.   She makes $75,000 a year as a manager for a large company.  Her employer gives a 50% match on her 401k contributions up to 10% of her pay.   She is in her 40's and has done a great job of saving up over the years and she received an inheritance a few years ago.  Ms Davis hopes to retire early around age 50-55.    Right now between her 401k and an IRA she has $450,000.  She also has another $300,000 in investments and her house is fully paid off.    With low expenses and living frugally she has been saving over 20% of her base salary towards retirement lately.

401k up to the match

If you have an employer match on a 401k then that should be the first priority for your investments.   For every $1 she puts into her 401k she gets another 50¢ from her employer.   Thats like an immediate 50% gain on her money.

Tax situation

Ms. Davis is solidly in the 25% tax bracket.   This is a very middle of the road tax rate.    The tax situation may go up or down somewhat over the years but she is not significantly advantaged with a Roth or traditional IRA at this point.

Early Retirement

Because she wants to retire early this throws a monkey wrench into the retirement savings planning.    401k and traditional IRA retirement savings are not available for withdrawal before age 59 without penalty.  You must be 59 1/2 years old to withdraw your money from a 401k or traditional IRA without a penalty.  However if you put money into a Roth IRA then you can withdraw your initial investment without penalty or taxes at any time.

Ms. Davis' situation is a bit complex.  We have a few factors pulling her retirement savings in different directions.   She should certainly take advantage of her employers 401k match.   That much is a given.   After that though her choices are less clear.   Her current 25% bracket is not very high nor very low so it doesn't push her hard towards either a Roth or traditional IRA/401k savings.     Her desire to retire early gives her an incentive to use the Roth since she can draw out her deposits before hitting 59 1/2 years.

Summary:  Given her desire to retire early and the extra flexibility that a Roth IRA gives, it would make sense for Ms. Davis to use the Roth IRA for her savings after she's maxed her employer 401k match.

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