Whether you’re a new professional or an established professional it’s never too early to start saving for your retirement. As one might expect, the longer you live the more resources you’ll need to sustain your lifestyle, so it’s always a good idea to start saving sooner rather than later.
When saving money for your retirement there are two common types of retirement accounts that you can invest in: an IRA (Individual Retirement Account) or an employer sponsored 401k account. Both accounts can be known as a Traditional Account or a Roth Account. In this blog I will specifically discuss Roth accounts.
When deciding between a Roth and a Traditional account it’s important to ask yourself:
When is the most advantageous time to pay tax on my income? Now or later?
Remember with all Roth accounts you pay taxes right now based on your current income tax rate. With a Traditional account you pay taxes when you withdraw the funds later based on your income tax rate at that time.
Is a Roth account right for me?
In regard to a Roth IRA’s tax implications consider whether or not you think your current income will be higher right now or higher during your retirement.
Jane is fresh out of college and a new employee at her firm. She's currently making $50,000 per year and is at the low end of her projected pay scale. Her marginal tax rate is 12%. It might make sense for her to invest in Roth accounts right now since the most income tax she can pay on that money is 12%
Now let's fast forward 20 years.
Jane is a CEO at her company and making $250,000 per year. She's at the highest end of her pay scale. Her marginal tax rate is now 32%. At this point in her career it might make sense to use a Traditional account now to defer the taxes until retirement.
Because Jane is making $250,000 per year she's in a high tax bracket - right now approximately 32%. She knows when she retires in 5 years she only needs $80,000 per year to live a great life in retirement. That would put her in the 12% tax bracket.
Jane is deferring paying taxes now at 32% because she thinks in retirement she can pay taxes on that money at 12%. She's effectively saving 20% on income taxes alone.
That's a very simplified explanation of when to use a Roth account and when not to but I wanted you to see that neither strategy was right for her 100% of the time. She used both strategies to her advantage and created tax diversity for herself in retirement.
Keep in mind we can't control taxes but we can control when and how we pay them.
Which is right for me?
When it comes to choosing between a Roth IRA and a traditional IRA, like most aspects of personal financial planning, there is no right answer that covers everyone. The right answer will be unique to each person's financial situation. Everyone is going to have a different preference depending on when they want to pay their taxes, withdraw their distributions and more. However, it’s important to compare the pros and cons of each before making a decision if you want to make the optimal choice for you and your family.
You need a plan
A goal of retiring - without a plan - is simply a plan to run out of money. At 80/20 Financial Services our specialty is retirement planning for electric cooperative retirees and retirees in general.
We help our clients increase their income, protect their assets and minimize their taxes.
Contact us for any general questions.
Click here to schedule your retirement consultation. The consultation is free and without obligation.
Click here to join our email list.
For more articles about retirement planning and investing click here.
80/20 Financial Services is an Independent Registered Investment Advisor (RIA) registered in the state of Missouri (CRD# 300772). We help clients in Missouri and throughout the United States prosper in retirement. Being independent allows us to work exclusively for YOU.