Ok . . .tax day is officially over. For real this time. No redos. So are you happy? Are you sad? Either way, you probably want to lower your lifetime taxes paid. Right? Today is the first of a two-part breakdown of Roth IRAs vs traditional IRAs. Buckle yourselves in for the benefits of a Roth IRA
The key difference between a Roth IRA and a traditional IRA is when you’re taxed on contributions: With a Roth IRA, you contribute money that’s already been taxed, so when you withdraw funds later in life (age 59½ is the minimum you can withdraw) you face a huge tax bill on the contributions or the gains. Try an online calculator to see the difference between a retirement account at age 59 and age 69. You’ll want to wait to withdraw your money. Trust me.
Why Use a Roth?
Roth IRAs are our go-to account for easy retirement planning. Most investment companies offer Roths. We are particular about Vanguard account, but really any low-fee account is fine. Emphasis on fees under 1%. Like well under 1%. Tax rates are likely as low as they are going to be for a long time thanks to the recently passed GOP tax bill. Basically, you’re contributing money in a tax bracket that is likely lower than the one you’ll be in the future, so you’re locking in the lower rate. If you plan on retiring in the future, you won’t earn income in retirement and your effective tax rate will be much lower than your tax rate now. This is why Roths are popular.
Roth IRAs Just Became an Even Better Deal for Retirement Savings
A Roth IRA is usually touted as a good deal for younger workers: You pay taxes on money going in and reap the benefits of all the gains.
Remember, you aren’t penalized on withdrawals from the principal contributed to your Roth. So let’s say you contribute $10,000 and early $100 in the first month. If you have an emergency the next month, you can pull any portion of that $10,000 out of the account without penalties at any point in time.
There are no minimum distribution requirements, meaning your children can inherit your Roth—whereas traditional IRAs have required minimum distributions beginning at age 70½. This really helps people with generational planning.
Hint, you can also use Roths to supplement a 529 plan. IF you have children, you need a 529 plan. The new tax plan allows a 529 plan to pay for pre-college education as well. Fund your 529 now! Check out our article on other tax deduction ideas.
The Drawback
The drawback for Roths: The amount you can contribute starts to decrease if you earn $120,000 per year for an individual in 2018 or $189,000 if you’re married and file taxes jointly, and completely phases out at $135,000 for individuals and $199,000 for couples.
How to Open a Roth IRA
If you have a 401(k) through your employer, absolutely contribute up to the match, and then consider directing a portion of your paycheck to a Roth (the current limit is $5,500 per year, and $6,500 per year if you’re 50 or older.
If you decide to go with a brokerage (Vanguard), here are some other things to take into consideration about the account offerings, per NerdWallet:
- Has low or no account fees.
- Offers a large selection of no-transaction-fee mutual funds and commission-free exchange-traded funds.
- Provides strong customer service and investor education, especially if you’re new to investing.
- Has a low account minimum and low fund minimums — these are two separate things.
What to Invest In?
You then select what you want to invest in, which could be individual stocks and bonds, or mutual funds (or sometimes other investments, like options). You could also pick a target-date fund (we love these), or have an advisor make choices for you, but you’ll pay more for both of those options. If you don’t go with a target date or actively managed fund, you’ll want to pick a mixture of index funds and ETFs to invest in—trading individual stocks will get pricey and you’re not going to beat the market. Do some research before you select your funds, but don’t go crazy. You won’t be able to predict the market. Pick a low fee fund and watch it grow. Even the S&P 500 is up over the last decade. If you’re young, risk is your friend. If you are near retirement age, try changing your allocation to more bonds and less stocks.
Once you’ve settled on your asset allocation, don’t forget to automate contributions so you’re consistently adding to your account—but never more than the $5,500 limit. Then: enjoy your tax-free earnings. Pay yourself first every month by funding your Roth.
Stay rational.
-B&T