Roth, IRA, 401k, SEP … what the heck do all these letters and numbers mean and where do I begin?! I hear this a lot in my line of work but there’s actually a very simple approach to decide whether you should save your retirement monies within a Traditional IRA or Roth IRA. Ask your CPA! Well, while that is the best answer, here are a few tips to help point you in the right direction!
Tax Bracket Considerations
Your tax bracket is a good starting point to weigh your options because a Roth IRA allows you to put “after-tax” funds in a retirement account and it grows completely tax-free. When you retire, you are able to take out the money you originally deposited and paid taxes on (the basis), as well as all the growth that was able to grow all without having to pay any additional taxes!! If you are in a relatively low tax bracket today, compared to where you may be in the future, it may very well make sense to contribute to a Roth IRA with your after-tax money (essentially part of your net take-home pay) if you believe your future tax rates will be much higher.
A Traditional IRA makes sense if you are in high tax bracket today and either need a tax deduction or believe you will be in a lower tax bracket during retirement. It is completely the opposite of a Roth as you are contributing “pre-tax” funds in a retirement account, it grows tax-deferred, and it isn’t until you withdraw the funds that you pay taxes based on tax rate while you make withdraws. While there are no income limits when contributing to a Traditional IRA (like there are with Roth IRAs), the tax deduction you receive from contributing may be eliminated or reduced based on your income. (But this is where your CPA comes in and can teach you about non-deductible IRAs to Roth conversions).
People will ask, “what if my tax rate will remain the same in retirement as it is today?” If that is the case then you want to consider your age. If you are in your 20’s or 30’s, you have another 30 plus years to save and time to allow that compound interest take place! When you are young, a Roth IRA is typically the better option as 20 and 30 year olds are usually in a lower tax bracket (being in the early stages of their careers) and a lot of time to allow their investments grow tax-free. This can be very lucrative especially since we don’t know what the tax code will look like in 30 years.
When Should I Not Contribute?
Contributing to Roth or Traditional IRA is great but there are several other retirement account options available. For one, if you have a retirement plan though your employer that offers a free match on contributions then you should be taking advantage of that. If you have any funds left over thereafter then apply it to any high-interest debt you have outstanding. If you have no employer plan or expensive debt then a Roth or Traditional IRA are good options to consider. Just remember, there are several things to consider depending on how complex your situation is but tax-bracket and age can hopefully help you determine whether you should go pre-tax or after-tax. If you’re a beginner at investing, make sure you read this post.
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