Written by Kyle Thompson, MBA
One of the most common questions I get is “should I contribute to a traditional IRA or a Roth IRA”? Actually, the question is so common you can find it all over Google. The most common answer, and the most common sense, is that you should go with traditional IRA if you think your tax rate will be lower in retirement than it is now, or a Roth IRA if you think they will be higher. While that is technically correct, things are a bit more nuanced than that, and, if planned correctly, can add up to hundreds of thousands of dollars in tax savings. Yes, you read that right!
- First off, no one stays in the same tax bracket their entire life. Earnings tend to rise throughout your 20s and 30s, peaking in your 40s and 50s. In fact, the average college-educated 45 year old earns roughly twice as much as their 25 year old counterpart, and is likewise in a higher tax bracket. Depending on your retirement goals, you will likely be in a higher tax bracket at 65 than you were at 25, but lower than at 45, so it wouldn’t make sense to defer taxes at 15% just so you can pay 25% later. If we take our common sense answer to the traditional/Roth question above, you should emphasize Roth accounts in your 20s and 30s, and pre-tax accounts in your 40s and 50s.
- What most people don’t know about pre-tax accounts (401k/403b/traditional IRA, etc) is that good ol’ Uncle Sam eventually wants you to pay taxes on that money, and will force you to start taking distributions at age 70. These distributions can actually be much more than you need for retirement income, potentially pushing you into a much higher tax bracket! To avoid this tax bomb, you can take distributions from your non-qualified and/or Roth accounts early on in retirement to keep your taxable income low, while doing Roth conversions on your pre-tax accounts to lock in those low tax rates!
- Married couples have some planning opportunities with retirement accounts that single people do not. For example, if one spouse decides to stay home to raise children and household income goes down, that means you are likely in a lower tax bracket. This creates a perfect opportunity to convert old pre-tax accounts to Roth for a much lower tax rate than when you first deferred it. Additionally, the stay-at-home spouse can still contribute to an IRA, despite not having any earned income.
- While it is not fun to think or talk about, divorce also creates some unique planning opportunities, particularly if one spouse has low or no income but receives part of the other spouse’s pre-tax accounts. Those pre-tax accounts are eligible for conversion to Roth accounts, likely at a lower tax rate than when he/she was married. However, there are complicated rules around this, so make sure you talk to your financial advisor and/or CPA before doing so!
- Last but not least, business owners have a whole host of unique opportunities! This could be an entire article itself, but I want to focus on one thing here- business losses. Every business has bad years, and most new business owners have negative income their first few years while they get off the ground. While you cannot contribute to retirement accounts in years where you have no earned income, you can still do Roth conversions. For example, if you have a $100,000 pre-tax IRA of some kind, along with $100,000 in business losses for the year, you can convert the entire account to Roth, tax free. TAX. FREAKING. FREE. How cool is that?!
I hope this article gave you a few ideas, because financial planning is way more than just how much to save and what to invest in. Done properly, it will save you piles of money on taxes, which means more income for you, along with less headaches and anxiety about your finances. This is the part of the article where I do a shameless plug for myself and my services as an advisor, so click the link below and let’s get started!
This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at kylet@leetownadvisors.com.