Investing in the IRA Alphabet Soup
One of the most frustrating things about retirement planning is simply the multitude of choices: deferred comp, IRA accounts, SEPs, 457s – it’s enough to make your head spin. You could always take a gander at the IRS website for a brief explanation of each type of account, but bring your coffee. Reading materials from the IRS run the spectrum from “dull” to “listening to Ben Stein talk about the differences between a Cournot & Bertrand game theory model”; that is to say, less than thrilling for most of you. Fortunately though, I find this sort of material to be quite interesting.
For the purposes of this post, I’m going to focus on Traditional and Roth IRA’s, as well as a company 401(k); perhaps at a later date, if the demand is great enough, I’ll create a post on SEP’s and 457 accounts. First though, let’s start with some basic warm-ups to get the blood flowing before we get into the nitty-gritty. IRA stands for Individual Retirement Account and you don’t get rich by simply having one. An IRA is, more or less, a box – mostly more. In fact, let’s just call it a box. This box is a place where you store different items to accrue wealth. These items are things like CDs, stocks, bonds, mutual funds and ETFs. For what it’s worth, these items are called “investment vehicles”. Now let’s get into the meaty stuff!
Roth vs a Traditional vs a 401(k)
The main difference between a Roth IRA and a Traditional IRA is simply how you contribute to them. The Roth takes post-tax income, which is the actual wage you take home from work, and contributes into the account with that money. Due to that, the money you withdraw when you retire is tax free! To compare that to the Traditional IRA, you contribute on a pre-tax basis – that’s the money you actually earned in a wage before deductions were taken out. When it comes time to retire, the withdrawals you receive from the Traditional will be taxed at your current tax rates in retirement. Side note, some people are not able to take IRA contributions directly from their paycheck and end up contributing post-tax money to a Traditional IRA. If that’s the case, you file the amount contributed on your taxes and it will count as a deduction towards your earned income so, effectively, you’re still contributing on a pre-tax basis. Both the Roth and the Traditional have a full array of investment products that can be purchased and both provide different advantages for different products – more on that later. The maximum you can contribute to either of these accounts is $5,500
Next up is the 401(k). The 401(k) is kind of like an employer sponsored Traditional IRA. It’s contributed on a pre-tax basis and, though not required, many times employers will match an employee’s contribution up to a certain amount. The core advantage of the 401(k) over the a traditional is that as an employee, you can contribute up to $18,000 a year and the total contributions (between you and your employer) can reach up to $53,000 a year. Aside from the contribution limit differences between the Traditional and a 401(k), the other major difference is the type of investments you can use. Because a 401(k) is employer sponsored, they generally have a limited selection – usually a few choice mutual funds that invest in stocks, some that invest in bonds, and maybe a Real Estate Investment Trust to try and diversify into real property; Whereas the Traditional, because it’s offered through a bank or intermediary, can invest nearly anything you wish. Be aware, if you have a 401(k) through your employer you can still contribute to a Traditional IRA, however, those contributions will likely not be tax deductible.
Using the Accounts to Your Advantage
Given that the accounts are treated differently in the IRS eyes, it makes sense that they would have unique tax advantages. Let’s consider the Traditional first:
Remember that the Traditional defers taxes, so if you think your tax rate will go down in retirement, you would want the Traditional. It’s a fact, once you lose your steady wage, most people will have less taxable income; that’s why the Traditional continues to be a popular product. Let’s see you’re a single filer nearing retirement and bringing in right at $43,000 a year. Through careful planning and cash flow management you know your total expenses for the year in retirement will be exactly $34,000. Between Social Security and your Traditional IRA withdrawals, your yearly income will be exactly $37,000. This takes you from the bottom of the 25% bracket [Which is $37,651 to $91,150] to the top of the 15% bracket [Which is $9,726 to $37,650], and thus your withdrawals are taxed at your current 15% meaning your IRA will last you even longer!
The Roth pays taxes upfront, so if you think your income will go up in retirement, you would want the Roth. This is also beneficial for a young professional because we’re faced with 40 years of wealth accrual. Based on the history of the market, over 40 years, your money will grow. Being able to withdraw those capital earnings tax free is a pretty sweet deal. I personally favor Roth IRA’s over a Traditional. My belief is that you’ll want to live on roughly the same amount that you retire on – at least for the first few years – so worrying about proper tax bracket placement doesn’t make sense. Further, most people will see their wage increase as they gain experience. That means if you start a Traditional early on in your career and you experience a drastic wage increase from what you imagined you would retire on, your tax planning is essentially moot; had you put it in a Roth IRA from the start, those gains would grow without the specter of taxation at the end! The Roth also has a few other benefits, like no withdrawal penalties and no required minimum withdrawal when you reach 70 ½ years old. I really like the Roth as an investment tool, so expect a post dedicated to it at some point.
Whether you believe in the Traditional or the Roth IRA accounts or invest in your company’s 401(k) the most important thing is that you invest in your future! The sooner you plant the seeds, the bigger your money tree grows. So readers, which do you choose for your financial future – a Roth, Traditional, or are you using a 401(k)? Let me know in the comments below.