The past two weeks we looked at why a Roth Account is the best and why a Tax-Deferred Account is the best. While the last two articles hit on both 401(k) and IRAs, this week we are focusing on choosing between a Roth IRA or a Traditional IRA.
The decision matrix behind these two choices is a little different than choosing between a Roth 401(k) and 401(k). However, what is similar is understanding your tax bracket now versus your tax bracket in the future.
If you’re unsure about your future tax bracket it may be advisable to diversify between the two options. By diversifying you are positioned to manage the unpredictability of future tax rates.
An alternative rule of thumb is that you should contribute to Roth Accounts when you’re in the 15% bracket or early in your career but expect to earn more in the future. This means any individual earning $40,000 or less would choose the Roth account assuming they are on a career path leading to greater earnings. If you do not anticipate earning more throughout your career then it’s reasonable to contribute to a Traditional IRA.
To expand on that, if you are earning $50,000 – $60,000 early in your career its worth considering contributing to a regular 401(k) down to the top of the 15% tax bracket and then the rest to the Roth 401(k).
If you’re earning enough to be in the top tax bracket it would seem very likely you would want to contribute to a 401(k) instead of a Roth 401(k).
Beyond the tax timing decision, there are other characteristics that could make one account better than the other for your situation. Since a 401(k) or Roth 401(k) can eventually end up into an IRA we will look at the benefit of the IRAs only.
Roth IRAs are the best for … entrepreneurs?
A major reason that Roth IRAs are awesome is because of their flexibility. Money contributed to Roth IRA can be pulled out at any time.
One caveat is that if you rollover your Roth 401(k) to a Roth IRA there is a 5 year window before you can take an early distribution.
Since it’s a retirement account the idea of pulling money out early is tough for an advisor to tell you this is “ok.” The idea of taking Roth IRA money out for a personal expense is rarely advisable. Being in a real hardship makes it reasonable, but to buy a boat is not.
That said, a certain segment of the population should really consider the flexibility of a Roth IRA as the savings vehicle of choice. This demographic would be aspiring or active entrepreneurs.
Having access to savings in the event you take the leap of faith to start your business or to keep your business alive is invaluable. Entrepreneurism is about creating the life you desire. It is also an amazing way to build real wealth.
By choosing a Traditional IRA you are blocked from withdrawing that money until you are 59 1/2 unless you pay income tax and penalty on the money. This lack of flexibility can be the difference from starting or continuing your business.
Furthermore, entrepreneurs may be building an asset with real value later in life. During the working years you may be re-investing a substantial amount of cash flow into your business leaving you in a fairly low tax bracket. Yet, when you sell your business or stop re-investing into your business you may be in a significantly higher tax bracket. Basically, you will be retiring rich, leaving the benefits of a Roth IRA as the option of choice.
Traditional IRAs are the best for … super savers?
Traditional IRAs and Roth IRAs have the same contribution limits. So do 401(k)s and Roth 401(k)s. However, a certain segment of the population are considered super savers. These savers are saving 50% or more of their earnings, which positions them to retire early.
These early financial independence (FI) seekers can significantly benefit from utilizing the tax-deferral benefit of a Traditional IRA.
The reason tax-deferral is such a benefit for the FI population is because the income they need to generate in retirement is going to be significantly less (i.e. 50% or more) than their current earnings.
Once an early financial independence seeker retires they are automatically in a lower tax bracket leaving them with opportunities to convert these tax-deferred funds to a Roth IRA. Not only taking advantage of lower tax rates now versus later, but also opening that money up for penalty and tax free withdrawals prior to 59 1/2 if the 5 year rule is met.
What if I’m not an entrepreneur or super saver?
Most people would classify themselves somewhere in between being an entrepreneur and super saver. When you’re somewhere in between a recent study indicates that a Roth is the clear winner. You can read if yourself here to decide.
If you’re really unsure and aren’t seeking professional advice then doing a mixture both is perfectly fine!
Worth noting is that, the rules dictate where you can save the money. Not every employer will have a 401(k) and Roth 401(k) option. Income thresholds and whether or not you have access to any 401(k) indicate whether you can put money into a Roth IRA or Traditional IRA.
Ultimately, making the decision of whether to Roth IRA or Traditional IRA comes down to a personal decision for you. You can utilize an online financial calculator. You can utilize a professional advisor. The best way to know if you are making a wise tax decision is to work with a qualified tax advisor.
Do you want to understand how to make your money work for you and keep more of what you have earned?
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.