Tax

A comment that I often hear when talking to friends and family is, “I know I need to do it, but I’m just not sure where to start saving for retirement”. I think the reason that this is such a common refrain is due to the number of options and choices available. Having more options is usually better, but after a certain point it becomes too much. It’s much easier to choose between a vanilla or chocolate cone from your local soft serve, than it is to select from the 40 different flavors at the trendy new ice cream shop downtown. Will you have the pistachio & honey, the coffee chocolate chunk, or one of the other 38 flavors available?

So today I want to explain why I think the traditional IRA should be most folk’s first choice for a retirement account, but that you really can’t go too wrong by picking either of your tax advantaged account options. As always, everyone’s situation is different and it can be immensely helpful to talk to a professional before making any investment decisions.

There are two main retirement accounts that area available to everyone who earns an income, the IRA and Roth IRA, but before I dive into this I want to offer one caveat (I know, I know, I haven’t even started and I’m already making an exception). If your employer has a 401(k) plan and offers any match at all, even if it’s only 1%, then contribute at least as much into your 401k to get the full employer match before doing anything else. It’s hard to beat free money, but the stats say that about 20% of folks out there don’t take advantage of it.

The IRA (and Roth) in a nutshell

First, a short primer on the IRA. The IRA (Individual Retirement Account) is a type of savings account that offers you a few tax advantages as long as you leave the money in the account to withdraw after you turn 59 ½. In both a Roth and traditional IRA your money grows tax free. This means you do not have to pay any taxes on dividends, interest, or capital gains while your money remains in the account. For a traditional IRA you can deduct your yearly contributions from your income, lowering your taxable income for that year. Later in retirement when you withdraw from your IRA you will pay income taxes on what you withdraw. For the Roth IRA the reverse is true. Your contributions are included in your income and taxed before going into your account, so when you withdraw your money in retirement it is not taxed again. There are limits on the income you can make and still contribute to a Roth or claim the deduction for a traditional IRA. For the purposes of this post I don’t want to get too bogged down into those numbers, but you can find them all here at the IRS website.

I think this is the point in the decision-making process where most people throw up their hands and give up. Not only are you anxious about making the right financial decision in the first place, but we’ve also brought taxes into the discussion. Yay taxes!

But if you can stay with me for just a bit longer I will explain why this choice is not as complicated as it seems. When you do the math to compare the Roth and traditional IRA, the only thing that makes any difference are your income tax rates when you make your contributions and later in retirement when you make your withdrawals. And if they happen to be the same, then it doesn’t matter which type of account you choose! Most individuals can expect to earn more as they advance in their career, and they can also make an educated guess about their income needs in retirement. So you might think that your tax rate will be higher later on in your career, but maybe lower when you retire. The problem lies in trying to figure out what the tax rates will be on your income on those future dates.

The prevailing wisdom for the last few years has been that federal income taxes will have to go up in the future to pay for increasing entitlement spending, so it makes sense to plan on a higher income tax rate in the future. But we just had the biggest change to the tax code in over 30 years and taxes on corporations and business went down a lot, and for individuals they mostly remained the same or down slightly, with small changes mostly depending where your income falls in the newly created tax brackets.

The Real Benefit of a Roth or Traditional IRA

The biggest benefit is choosing a tax-advantaged account, making steady contributions, and letting it grow. By saving and investing in a tax-advantaged account like an IRA you can expect to gain an extra 0.7% – 2.7% vs investing in a standard brokerage account. For someone contributing the maximum of $5,500 per year, the additional gain adds up to an additional $58k or even $277k after 30 years. That’s a huge benefit that you lose out on if you decide to give up on using these accounts because the choices seem too complicated.

I was inspired to write this post after reading this great post on Alpha Architect which is where the 0.7% – 2.7% number comes from. In the post they go deeper into the details and crunching the numbers on the different tax benefits of investing in tax advantaged accounts like IRAs and 401(k) plans. Consider my post a primer and if you want to get more into the details and learn more, please head over to their site and give it a read.

“So, this is great, you’re saying all I need to do is flip a coin and pick one of the two to get my extra returns? All right sign me up.” Great! I’m glad that I’ve been able to get you excited about IRAs. But before you pick one, there’s one more thing I want you to consider before making your choice: Entrepreneurship and Income. 

Careers and the changing nature of work

Careers have changed and evolved over time. While many of our parents or grandparents may have worked at one job their entire careers, most of us in the workforce today can reasonably expect to switch jobs multiple times in our career. And many people these days have a side business or “side hustle” that they work at for additional income. Some of these opportunities can grow to the point of becoming a full-time gig and replacing your main job.

For those individuals that have lower income in some years because they are working to get their business off the ground, or gaps in employment moving between jobs, the traditional IRA has one clear advantage: convertibility. You can convert the money in your traditional IRA to a Roth IRA and pay the income taxes in that year. If you have a transition year, moving jobs or starting a business, where you are making much less than you normally do you can take advantage of that opportunity and convert some of your IRA contributions to a Roth IRA and pay the lower income tax rate on that conversion. At that point it will continue to grow tax free in your Roth IRA account, and as your income rises back to normal levels you can go back to making contributions to your traditional IRA account.

Pay taxes now or later, just not in between the two

To sum up, consider the traditional IRA as your first choice because of its convertibility during periods of low income. Nobody can tell you for sure what tax rates will be in the future, so don’t stress too much about the difference between the traditional or Roth IRA. The big thing is to take advantage of the opportunity to invest in one of the tax-advantaged accounts available to you because the main benefits for all of them is the tax deferred growth while your money is in the account. And please, please, don’t be part of the 20% that skips out on your 401(k) match.I hope you enjoyed this post and that it helps reduce the intimidation that comes along with researching and making these big financial decisions. If you have questions or you would like some help planning for your retirement or other financial goals, you can learn more by visiting http://www.steadyclimbfp.com or sending me an email at chris@steadyclimbfp.com.