The recent economic events brought on by the coronavirus have definitely made us all pause. We’ve realized how our lives, routines, and finances aren’t as guaranteed as we thought. I’ve seen how greatly a family’s income and long-term savings can be impacted by unknown events like this.
I’m writing this in the midst of a global pandemic. However, these concepts for saving are important both now and for your future! Thankfully, if we diligently prepare for our financial futures, we will be ready to face financial hardship when it comes. Not just face the hardship – but overcome it and live with financial peace throughout our whole lives!
I realize that a primary roadblock to investing is lack of knowledge and resources. So, I want to focus on a basic way that many people can save and invest. Mostly, I want to distinguish between two different methods of saving and explain which one might be best for you!
What is an IRA/401(k)?
I am lumping Individual Retirement Accounts (IRA) and 401(k)s together because they are taxed the same way. One is simply owned on your own and one is owned as part of your employer’s retirement plan.
These accounts have A LOT of “nicknames.” You might hear them called:
- Traditional IRA
- Rollover IRA
- Pre-Tax IRA
- Pre-Tax 401(k)
- Tax deferred account
Don’t ask me why they can go by so many names… This is why people don’t like finance!!
Here is what you need to know:
When you put money into an IRA, you get a tax deduction for it. So, if you put $6,000 into your IRA in 2020, $6,000 of your income will not get taxed!
Who doesn’t love not having to pay tax!?
Ah, yes, there is a catch. You do have to pay taxes eventually. Let’s say you retire and are ready to start living off the money in your IRA. You take $20,000 out of the IRA in year 2050. That means in 2050, you have to pay taxes on that $20,000. Your tax rate will be whatever tax bracket you are in that year. So, if your effective tax rate is 20% in 2050, you will pay $4,000 in taxes.
The bright side is that you are usually in a lower tax bracket during your retirement years than during your working years.
What is a Roth IRA/Roth 401(k)?
Think about these accounts being the opposite of the options discussed above.
You DO pay taxes on the money you put in the accounts now, but you DON’T pay any tax when you take the money out.
For example, if you earned $50,000 in 2020 and you put $6,000 into a Roth IRA or Roth 401(k), you will still be taxed on $50,000 of income… No deduction. That may sound like a bummer.
However, by 2050, that $6,000 will grow!! As long as Roth rules exist like they currently do, you will never have to pay taxes on any of that growth or money again.
So, what’s better? IRA/401(k) or Roth??
Well, from a high-level view and long-term tax perspective, the Roth option is the better tax planning tool most of the time.
What to consider when choosing your option:
1) Can you afford to pay taxes now?
If you can’t afford saving without getting the tax deduction, you should go with the Traditional IRA/401(k) option.
2) What is your current tax bracket?
If you are in a very high tax bracket, there could be argument that you should take the tax deduction now and do the Traditional IRA/401(k) option. Then, maybe in retirement, you will be in a lower tax bracket and can pay the tax then. The downside is that you will have to pay tax on all of your gains.
There are also income limitations. For Roth IRAs, the amount you can contribute starts to phaseout once you hit an income of $196,000 (married) or $124,000 (single). Note that Roth 401(k)s do not have this income limit – only Roth IRAs.
There are a few considerations for IRAs that you can read about from the IRS here.
3) How close are you to retirement?
The closer you are to retirement, the less likely you are to receive as great a benefit from the Roth option. Why? Because less time means less growth that gets to avoid taxes. However, if you don’t plan to use the funds, they can grow tax free throughout the remainder of the account’s life.
4) What are your legacy goals?
Currently, Roth IRAs are the more desirable asset to leave to inheritors. Why? Because your inheritors will not have to pay any taxes when they receive or take money from the accounts (unlike an inherited IRA).
5) Will you need to live off of your investments in retirement?
If you have a Traditional IRA/401(k), you have to take a Required Minimum Distribution (RMD) once you hit age 72. That means every year, you are FORCED to take money out of your investment account and pay taxes on it… Even if you don’t need the money to live at that time.
Reminder: Because of the CARES Act, no one has to take an RMD in 2020.
I am sure there are many other considerations I didn’t include on this topic. However, I hope I at least gave you some basic information and thoughts to consider as you are trying to decide which account to go with! If you have questions about investing, reach out to me and see if I can help!