The Traditional IRA, the Roth IRA, and the 401k are most common opportunities for individuals to defer income into the future. There are lots of articles regarding the rules and regulations for these vehicles, the IRS website has a great summary of all the vehicles available:
https://www.irs.gov/retirement-plans/plan-sponsor/types-of-retirement-plans
Knowing the rules are essential, but what are the implications of each choice in terms of financial planning? When and why is one better than the other?
The difference comes down to the earning power of each plan and when and how each plan is taxed (I like to call it “crossing the tax line”).
Assuming you are eligible for a Traditional or Roth IRA contribution, which is better?
Here’s a comparison chart to check eligibility:
https://www.irs.gov/retirement-plans/traditional-and-roth-iras
The best way to illustrate each option is through an example.
Say you are taxed at 25% (I know, current rates are different but 25% looks cleaner) and want to contribute $1,000 to a plan and will hold it for 20 years, earning 6% a year. At the end of that period you’ll distribute the full amount.
For the Roth you pay any tax in the contribution year, for the Traditional you pay in the distribution year.
Here’s what the cash flows look like in a table:
The Roth is taxed in the current year, meaning only $750 is actually contributed. The gross amount is contributed to the Traditional IRA and it grows to over $3,200 in 20 years, but tax is still owed ($800 at 25%). Realize this: a Roth IRA and a Traditional IRA generate exactly the same result if you are taxed at the same rate over time.
What if you are taxed at a lower rate when you retire, say 20%, instead of the 25% when you originally earned the income?
Looking above, if your tax rate drops your tax liability in the Traditional IRA immediately drops, creating a planning advantage. This is what the planning profession has termed the ‘bracket drop’; meaning when you stop working your lower earnings will drop you down one or more tax brackets.
Conversely, if your tax bracket is forecast to rise by the time you are 65, then contribute to a Roth IRA. Anyone under the age of 30 should definitely consider contributing to a Roth initially:
Also, in the era of rapidly increasing budget deficits, there are two basic options for the government to cover forward obligations: hope the economy grows and tax receipts cover the imbalance, or increase tax rates. This could be the most compelling reason to contribute to a Roth IRA.
Finally, consider the 401k.
If your firm offers no matching then your 401k is essentially a Traditional IRA with a higher threshold of contribution (see the above link for limits).
But a 401k can be quite helpful if your employer offers a 3% or greater match.
Here’s the numbers in accordance with our previous example:
It’s difficult to predict future tax rates or one’s future tax bracket. Having a portfolio of differing tax treatments, in the end, is probably the best option. A bucket of Roth, a bucket of 401k (or IRA if that is not an option) and a bucket of taxable allows for greater flexibility when it comes time to start distributions.
In summary:
If you have a 401k with an employee match, max it. A 3% match is good, a 6% match is stellar.
A Roth is a great starting retirement vehicle, you can pay tax at lower rates when you’re starting out and it offers a useful ‘taxes paid’ source of retirement funds.
Whatever you choose, just start a discipline. Make automatic contributions if you can.
One caveat, build an emergency fund first. Distributing money from any IRA before age 59 ½ incurs a 10% penalty which can take away the original advantage of tax deferral you were building in the first place.
I enjoy working with clients who want to understand their finances and be actively involved in shaping their future. Please contact me if you have any questions or comments.
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Brian Kearns, CPA
Haddam Road Advisors
Ph: 312 636 3067
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