Traditional vs. Roth IRAs

Investors should take advantage of the government endorsed tax advantages of IRA accounts by maximizing their contributions each year. This guide gives you some information to decide whether a Roth IRA or Traditional IRA is best for you.

An IRA is an Individual Retirement Account. All IRAs of any type are held in custody at a bank or a brokerage, rather then by the owner, and they may be invested in anything the custodian has access to. These investments options change from custodian to custodian. Because of the fact that IRA’s require extra work for the custodian bank or brokerage, they often involve an annual maintenance fee. Some custodians will waive the maintenance fee when your account reaches a certain level, such as $5,000.

IRAs come in two main flavors: Roth and Traditional. Choosing the right type of IRA is a matter of deciding whether you’ll pay taxes on your money: up front (Roth) or upon withdrawl (Traditional). To help you decide, make sure to read our step by step guide on prioritizing your retirement investments.

For a traditional IRA, the only criteria to be able to contribute is sufficient income to make the contribution. For it to be most effective, however, the contributor should pay attention to other eligibility requirements for tax deductibility of the contributions. These requirements are based on income, filing status, and the availability of other retirement plans. All transactions in the account, including contributions, are not subject to tax while funds remain in the account. Only when cash is withdrawn from the account for any reason does federal income tax apply.

The Roth IRA, on the other hand, works opposite. Contributions are subject to taxation; however, qualified withdrawals are made without tax penalty. It also has fewer restrictions on withdrawal than the traditional IRA.

In both cases, all transactions that take place within the account, like capital gains, dividends, and interest, are made with no tax liability.

In addition, income limits, both upper and lower, are different for the Roth and traditional IRA, with the traditional IRA having a lower overall income range.

Advantages of a Traditional IRA

In traditional IRAs, contributions are often tax-deductible; for Roth IRAs, contributions are not tax deductible. And because the taxes on the traditional IRA are charged after you take cash out of the IRA, if you expect your income to be less after retirement (putting you in a lower tax bracket), then you should take a traditional IRA for the tax advantage you will have.

You may be able to withdraw cash from a traditional IRA early if necessary for purposes such as qualified educational or medical expense, or for buying a first home. You should, however, be aware that the penalties may be substantial.

The traditional IRA is designed to provide retirement benefits for lower-income workers, so there are income eligibility requirements to take full advantage of the tax benefits.

Benefits of a Roth IRA

A Roth IRA is better than a traditional IRA for those with a lot of disposable income who anticipate a healthy, larger income after retirement. The Roth IRA also has very liberal disbursement requirements, and does not have a forced distribution age like the traditional IRA.

A traditional IRA must be disbursed at a specific time, and an annual minimum distribution will apply after the owner starts making withdrawals after age 59.5. There are no such requirements on a Roth IRA, though early withdrawals of earnings – not contributions – can incur heavy penalties. There are exceptions similar to the ones on the traditional IRA, though, such as buying a first home and paying qualified educational expenses.

Contributions to your Roth IRA can be withdrawn at any time, with no federal tax penalty. And if you convert a traditional IRA into a Roth IRA, after a “seasoning” period that is currently 5 years, you can withdraw up to the total of the converted amount just like a regular Roth IRA contribution – resulting in potentially significant tax savings.

Because Roth IRA contributions are made from after-tax income, and it is not taxed on disbursement, it’s easier to determine what your IRA is actually worth. Withdrawals up to the total of contributions are federal income tax free (check state regulations, though), and withdrawals of earnings are often also federal income tax free.

You can have both a Roth and a traditional IRA at the same time.

Why your expenses might decrease in retirement

It is certainly true that you should invest as much as possible for retirement. However, if you don’t have as much as all the “experts” tell you you should have, don’t fret just yet. The good news is that for most people, some major expenses tend to decrease or completely go away in retirement. Because of this, you may be able to live comfortably off of as much as 30% less than your current salary.

Even though retirement will bring a level of simplification to your life – preparing to go there is going to be very complicated. There are so many factors that have to be considered and decisions that have to be made to make sure that when you do reach retirement age, all of your carefully laid out plans will have borne fruit and you can finally enjoy this new phase in your life.

The most important thing that you have to contend with on your retirement is the fact that, generally, you won’t be earning an income anymore. For most people who either have not set up a business or are not in a field where they can do consultancy, the salary “well” dries up when you retire and the accumulation phase of your life nears its end. This means that you will have to subsist on the savings you have accumulated over the years and any investments or pensions that you have drawn up before.

For most retirees the main area of concern is whether their funds will last them for the rest of their lives. How much of the money that they have can they safely spend each year to ensure that their funds will not run out.

These questions all come down to the fear that your retirement funds will not be enough.

The good news though is that there are some expenses that will decrease when you go into retirement and this will definitely help in extending your funds. Many of the things that you pay or spend for now will most likely disappear or decrease when you reach retirement. Among these are:

Work-related expenses. You can basically write off any work related expenses when you retire. You won’t have to commute everyday and thus eliminate taxi or subway fare, or if you drive, the cost of getting gasoline for your car. Another work-related expense that will be eliminated is the cost of buying professional wardrobe. Corporate dressing can really put a big burden on your budget but upon retirement you can say goodbye to this expense. One minor expense that is also eliminated is the cost of decorating your cubicle. Insignificant, really, but when you retire every cent saved will help.

Taxes. There are some taxes that you won’t have to pay anymore when you retire. Most of these are Social Security related taxes. Depending on the type of retirement investment, you may not have to pay any taxes at all.

Retirement plan contributions. When you retire you stop paying your retirement plan premiums. The good thing is, all of your sacrifice now pays off as your retirement plan now starts paying you instead.

Mortgage payments. If in your projected plan, you will finish paying off your mortgage by the time you retire, then that’s one less payment to worry about. Of course, if you fall for one of the new 50 year mortgages, you may be paying well into your 80s.

Downsizing. A change in your personal financial outlook will also have a big impact in lessening your expenses upon retirement. The first thing that retirees often do for practical reasons is to downsize. There’s no more need to maintain a five-bedroom house if all of your kids are grown up and have families of their own. There are some who even decide to leave the city and live in the country where the cost of living is significantly lower.

Whatever the case, chances are that many of your current monthly expenses will be gone in retirement. Of course, there may be new types of expenses related to health or even those monthly vacations you’ve been dreaming about! But keep in mind that when it comes to the basics, chances are that you will be downsizing your expenses and have more cash left over for living well.

Keep that in mind if you’re feeling the pressure of retirement looming. But for now, keep investing and everything should be fine.

Retirement Investing and Tax-Efficiency

The average investor isn’t aware of the fact that there is a huge difference in the total return of a standard stock investment versus a retirement investment.

Thankfully, the United States goverment has encouraged retirement savings by adding the benefit of tax efficiency both as it grows and either at the purchase or sale. In other words, you can either put pre-tax income into your retirement and postpone paying taxes until you retire, or you can put post-tax income in now, and never have to pay taxes again.

Despite the benefits of tax-efficient retirement investing, something that’s frequently forgotten when you invest for retirement is to actually consider the role taxes play and the effect they will have on the total return of your stocks. Keeping this in mind will help you make wise retirement investing decisions, both when you put the money in and when you take the money out.

You may have invested carefully in great stocks that performed well, and you may have hedged your 401(k). But what happens when you cash it in? Do you really know what taxes are going to do to you? If you’re like most people, the answer is no. Do you know, really well, exactly how much you’re going to need for retirement? Again, if you’re like most people, the best you can do is give a vague answer based on a guesstimate.

But the key to a successful retirement is knowing and understanding the relationship that your investments have to taxes. Here are some things to think about to maximize you money. First, calculate how much you’ll need for retirement:

  • What kind of lifestyle you want and how much you’ll need annually to support it.
  • How much your target number for your day of retirement should be.
  • How long you’ll probably be retired.
  • Where you’re going to live and whether you will own or rent your home.
  • How to provide medical and other insurance for yourself and your family.
  • How you’re going to spend the days, and what expenses are associated with that.

From these questions, you will have a realistic idea of how much you’ll need for retirement. Don’t forget to figure in the sale of your current house if you’re going to move, too; that can help you afford the lovely home in the Bahamas you’re set on. Then figure that you’re going to need about $25 in savings and investment for every $1 per year you need to live. This ensures you can live mostly on interest without touching your principal. You should probably also assume that your savings are the only income you will have; we don’t know what’s going to happen in this day of pension fund reneging and changing Social Security.

Once you have your numbers straight, you need to take a look at how taxes will cut into them. Do you have a tax-deferred pension vehicle, a 401(k) or an IRA? These are great for keeping your income taxes lower, and for using money from deferred taxes to build up your compound interest, but eventually you will have to pay the piper in the form of Uncle Sam.

In the case of the 401(k) and the Traditional IRA, your earnings are not taxed until you retire and start drawing the money, so it would be better if you were in a lower tax bracket during retirement. With a Roth IRA, you pay taxes before you put the money into retirement, and all your earnings are taken out tax free. This is the strategy to use if you plan to be in a higher tax bracket when you retire.

The cut you take from taxes would be easy to figure into your whole retirement plan – except that the tax rate is not predictable. It may be higher or lower than today’s; you just don’t know. This is where you need to start betting (or making educated guesses!). Do you think taxes will be higher or lower when you retire. Chances are, if it’s going to be ten years or more, and you are acquire wealth during that time, they’ll be higher. There is very little chance they’ll be lower. So take your current tax bracket, add about 1/3 of its amount to it, and figure that into your retirement numbers as the amount you’re probably going to be taxed. It’s an additional expense, but you have to plan for it.

But why, you might ask, should I use the tax deferred dollars if I’m just going to have to pay them eventually plus capital gains? Because the tax money in your account is free interest-drawing capital. This means that your money grows faster and goes to work harder. And because if you’re using a 401(k), your employer is probably matching at least a portion of your investments. Once you reach the top of the employee matching bracket, you might want to consider investing in a Roth IRA, which have better tax structuring for you when you retire and which also defer taxes.