When it comes to choosing between a traditional or Roth IRA, it really comes down to choosing between pre- and post-tax options. One way to convey this is to think of yourself as a farmer…would you rather pay taxes on your harvest or your seed? In terms of retirement options, the seed is your financial contribution to your account and the harvest is the growth of that contribution over time. For those that contribute to a traditional retirement account or 401K, you will not pay taxes on that money today (the seed), but rather when you retire (the harvest). The idea behind this is that you can lower your taxable income today and then defer the taxation on that money and its growth for later. When you’re older and retired, the common thought is that you will likely be in a lower tax bracket than when you were working, and therefore will have to pay less taxes on your harvest. However, this is not a guarantee. I’ve had several clients who ended up in a higher tax bracket upon retirement as they had multiple streams of income (ex: pensions, social security distributions from 401Ks, IRAs, rental income, etc). This is another example of why it’s imperative that you speak with a Certified Financial Planner™ Professional (ideally long before you’re ready to retire), to ensure you’re on the best path to Building A Better Financial Future.
Let’s review a simple mathematical example to showcase contributing to a traditional retirement account: If you make $80,000 annually and contribute $10,000 pre-tax to your 401K, the IRS is only going to tax you today on the $70,000 balance of your income. With the beauty of compound interest, the money you contribute to your 401k, will grow over time. You will not pay taxes on any of it until you are retired and start withdrawing the funds.
Another aspect to keep in mind…if you withdraw money from a traditional retirement account before the age of 59 ½, you are then required to pay income tax on that money plus a 10% tax penalty (some exceptions apply). By waiting until age 59 1/2, you avoid paying the 10% penalty tax.
A Delaware Senator by the name of William Victor Roth helped to champion the Taxpayer Relief Act of 1997, which ultimately resulted in the Roth IRA. Contrary to the traditional IRA, the Roth IRA takes post-tax contributions. Let’s use the mathematical example from above: If you make $80,000 annually and contribute $10,000 to your Roth 401K account, the IRS will still tax you on the entire $80,000 income. However, if you maintain your Roth account for a minimum of 5 years and until the minimum age of 59 ½, all of that money and its growth is then tax free income. If for some reason you need to dip into your account before the age of 59 ½, and if your distribution does not fall under any exception, you may have to pay taxes and a 10% penalty on the earnings portion of your distribution. However, as long as you only withdraw what is considered part of your initial contribution, you don’t have to worry about the 10% tax penalty or income tax. There is a 60-day window for every 12-month period where you can roll your withdrawal back into your account (either Roth or traditional) and forgo the 10% tax penalty and taxes as well.
A Roth IRA does not have minimum requirements for minimum distributions once you reach a certain age, unlike a traditional IRA. Also, once you have reached the age and holding period requirements, your Roth IRA distributions are not considered income, so it does not affect the taxability of your social security benefits. Does that mean social security benefits are taxable?! Yes and no. If someone lives on social security alone, then that money is likely not taxable. However, if you are making income from a job, 401K distribution etc. in addition to your social security, this may trigger taxation on your social security benefits up to a certain limit.
Whether you are contributing to a 401K, 403b, or Roth 401K, the maximum annual contribution is $19,500 if you are under the age of 50. If age 50 or older, you have the option to contribute an additional $6500 “catch-up” contribution ($26,000 annually combined total) plus any match that your employer may offer. Let’s say you’ve maxed out your employer retirement accounts or simply don’t have one, you are able to contribute to a Roth IRA or traditional IRA outside of the workplace if you are under the income limits. Roth and Traditional IRA contribution limits are currently $6,000 per year with an additional $1,000 catch-up contribution for people age 50 or older. Like all things tax related, there are a variety of guidelines based on income, marital status, age, etc to consider. A Certified Financial Planner™ professional can walk you through these guidelines to help you make the best choice possible.
The current tax brackets are in effect until December 31st 2025. This is when the Tax Cuts and Jobs Act is scheduled to sunset. While there is the possibility of extension, we have to consider the amount of debt the country has accumulated, the economic hit related to COVID-19, the stimulus package (possibly more to come), and several other factors. At some point the country must start making this money back, and one of the most efficient ways of doing so is through taxation of its citizens…yet another aspect to consider when deciding between a traditional and Roth IRA. But don’t worry, a Certified Financial Planner™ professional can guide you through all of this!
WHERE TO GO FROM HERE?
Listen to the On My Way To Wealth Podcast for additional information and specific examples. Consult with a Certified Financial Planner™ professional as he/she can provide you with the knowledge and expertise critical to help you Build A Better Financial Future!
As always, thank you for checking out my podcast and blog post! If there are any topics you would like to learn more about, or if you would like to schedule a free financial consultation with me, please email me at Luis@onmywaytowealth.com! All of my podcast episodes can be found at www.onmywaytowealth.com and on all major podcasting platforms. For my business site, please be sure to check out www.buildabetterfinancialfuture.com. I look forward to helping you Build A Better Financial Future!