When it comes to putting money away for retirement, there are always a lot of questions. How much will I need to live comfortably (or simply to pay the bills)? How much do I need to invest each year to achieve my target balance? Where do I invest the money?
For most people, the first thing to do is to contribute to your employer-sponsored 401k plan up to any match provided by the company. Many employers match your contributions up to certain thresholds, meaning you are basically getting “free” money.
However, I know there are readers out there where a 401k plan isn’t available. Maybe they are self-employed, work at a small business, or their employer simply doesn’t offer a 401k. Or maybe your employer offers a plan, but no matching. In these cases, your investing should be primarily into an Individual Retirement Account (IRA). There are two types of IRA’s: Traditional and Roth. Each type has its advantages and disadvantages.
A traditional IRA is very simple and can be opened at any investment firm either online (Vanguard, Fidelity, etc.) or at a physical branch (Edward Jones, Merrill Lynch, etc.). The basic mechanism is just like a 401k plan. You put funds into your account, select which mutual funds you would like to invest in, and watch your money (hopefully) grow. Contributions to a traditional IRA are tax-deductible. For example, if you invest $5,000 this year into a traditional IRA your taxable income will be reduced by $5,000. Come tax time, you will owe $750 less in taxes if you’re in the 15% bracket ($1,250 less if you’re in the 25% bracket). When you reach age 59 ½ you can begin withdrawing funds from your IRA, and those withdrawals will be considered taxable income at that time. One other caveat is that if you withdraw funds from your IRA before age 59 ½ you will have to not only pay regular taxes on the withdrawal but also a 10% penalty tax.
A Roth IRA works the same way as a traditional IRA in that you open it the same way, and select mutual funds the same way. However, there are differences when it comes to income and contribution limits, taxes, and withdrawals. Unlike a traditional IRA, there are no immediate tax benefits for contributions to a Roth IRA. So, if you invest the same $5,000 (which also happens to the maximum Roth IRA contribution for a single person), when it comes tax time you won’t receive a deduction for your contribution. However, when you reach retirement age, when you withdraw funds from a Roth IRA you do not pay taxes on the amount withdrawn. There are also some other advantages, being able to withdraw funds (with some stipulations) before reaching age 59 ½.
Which is Better: Traditional or Roth?
Deciding which type of IRA is best mostly depends on what you think is going to happen to your income tax rate between now and when you plan on retiring and withdrawing funds from your IRA. Here is the general strategy:
- If you expect to be in a higher tax bracket in the future than you’re in now, it will pay to use a Roth IRA.
- If you expect to be in a lower tax bracket in the future than you’re in now, it will pay to use a Traditional IRA.
- If you expect to be in the same tax bracket in the future that you’re in now, it technically makes no difference whatsoever. It may even be slightly better to use a Traditional IRA (you’ll see why below).
Predicting your future tax rate is no easy task, especially if you are only in your 20′s or 30′s. Who knows how the political and economic landscape will have changed by then? However, there are some clues to use as a guide.
Historical Tax Rates: Today’s income tax rates are some of the lowest we’ve ever had. On the flip side, government spending has never been higher. The combination of these two situations has created a fiscal deficit that is threatening the economy. Before long something is going to give. Either tax rates will increase, government spending will decrease, or some combination of the two.
Changing Spending Needs: Many retirees see their overall expenses decline in retirement. Mortgages get paid off, there are no more kids to send to college, etc. These can be partially offset by increased healthcare costs, maybe more spent on travel, etc., but on average you need less money in retirement than you do earlier in life.
Death of a Spouse: No one wants to think about this, but it is a sobering reality that as we age we face the possibility of our spouse passing away. After the costs of end-of-life-care and funeral expenses, the surviving spouse will most likely spend less money than when the household consisted of two people.
I mentioned above that if you expect your future tax rate to be the same as your current rate, it technically doesn’t matter whether you invest in a traditional or a Roth IRA. The numbers bear this out, but only if you invest the money “saved” from the tax deduction on the traditional IRA.
For example, you decide to invest $5,000 a year into an IRA. If you invest this every year from age 25 to age 67 (earning an average annual rate of 7%), you’ll be able to withdraw $80,000 a year (earning an average annual rate of 4%) until age 90.
If you had a Roth IRA, this $80,000 annual withdrawal is tax-free, meaning you get to keep all of it.
If you had a traditional IRA, this $80,000 is taxable. If you’re in the 15% bracket, you will get to keep $68,000. The thing to keep in mind is that to achieve the same $80,000 net as the Roth IRA, using a traditional IRA you have to invest the annual tax savings as well. So, using our example in the 15% bracket, you actually need to invest closer to $5,750
Perhaps the best strategy is to put a portion of your retirement money in a traditional IRA and another portion in a Roth IRA. This way you’re perfectly hedged no matter what tax bracket you’re in during retirement.