Why a Roth IRA might not be the first choice for your retirement contributions

Investing your money

You’ve heard it said a million times.  “You need to invest your money”.  “Stop working for your money and put your money to work for you”. You’ve read about the success stories. Maybe you have friends that are sitting on large nest eggs and are actually looking forward to retiring instead of dreading it.  You want to do that too.  You’re ready to do that.  But how do you actually do it? And where do you start?

Where to invest

If you’re planning for retirement you’ve got options. Lots of them.  From IRAs to 401(k)s to Roth versions of both, Sep plans and pensions there’s a plethora of ways to invest your money.  So where do you start?  You don’t have enough money to max out all of these types of plans, so which one should you contribute to?  Or should you contribute to them equally?

If you’re like most people you’re probably thinking a Roth is your best bet at this point.  After all, those gains appreciate tax-free for life, and the principal can be withdrawn penalty-free once the account age reaches 5 years, even if you haven’t hit your retirement age yet. All the financially-savvy people seem to be talking about them after all, so it must be a good option you 

Why a Roth isn’t always the best option

While contributing to a Roth IRA or 401(k) plan is a great option, it’s not necessarily the best option for you. To understand why, we need to understand what a Roth Retirement account actually is, and how it differs from a standard retirement account.

The primary difference between a standard retirement account like an IRA and a Roth is that Roth accounts are funded using after-tax contributions, but then grow interest free forever.  Standard retirement accounts are funded using pre-tax contributions but then taxes are due when the money is withdrawn (Please note that when we say taxes are deferred we are referring to federal and state taxes only.  FICA taxes are still collected)

So which one is better? 

The answer is it depends.  On what? Well on your tax bracket.  Or rather, on how your tax bracket will change between when you are contributing money (now) and when you are withdrawing money (when you retire). Suppose you spend your whole life in the 24% tax bracket and it never changes. I’m that case it actually doesn’t matter whether you go with the Roth route or the IRA route. You’ll walk away with the same amount of money either way.  

Don’t believe me?  Say you want to contribute $3000 of your pre-tax salary to a retirement account.  If you were to contribute to an IRA, you would be able to contribute $2770.5 (your 7.65% fica taxes are still collected here). Say it then grows at a 10% rate for 25 years.  At the end of this 25 year period your $2770.5 contribution has now ballooned to $30,017.55. If you were to withdraw all that money, after paying the taxes due at your 24% tax bracket you would be left with $22,813.34.

Now let’s say you were to contribute the same $3000 pretax amount to a Roth.  Well, you’re $3000 is really only $2770.5 due to the fica taxes that are taken out, and your $2770.5 actually only amounts to a $2105.58 contribution as you need to pay income taxes on that contribution as well. So assuming the same growth rate of 10% over 25 years, your balance will now appreciate to $22813.34. The benefit here being that if you were to withdraw all of that money, you wouldn’t owe a dime in taxes.   Do you see how either way you end up with the same amount of money?

But its not always like this.  Imagine if you are in a high tax bracket while you work but you will be in a lower tax bracket during retirement.  Contributing to a roth would Actually cause you too loose some money that you would otherwise keep if you had contributed to an IRA.  Or suppose your tax bracket varies from year to year?  Some years it would be better to contribute to an IRA or a 401(k) while other years it would make more sense to contribute to a Roth IRA or 401(k).

My personal experience

I’m going to use a very real example here.  My wife and I have both been working the past couple of years. We both make good money, and so our tax bracket is fairly high.  We are preparing to have a child soon, and have decided that my wife will no longer work once we have children. We’ll be down to one income and in a much lower tax bracket for the foreseeable future.  For the few years that we are pulling a double income, we want to defer as much of that income as possible to keep ourselves in a lower tax bracket so a 401(k) & IRA is the way to go.  Once the baby comes though, we won’t need to defer any of that income to stay in the lower tax bracket.  We simply won’t earn enough money to exceed it.  So we’ll stick with Roth Contributions after that.  

Please note that if you’re retirement plan offers contribution maxing, you should always contribute enough money to earn the full match, regardless of whether it’s tax-deferred or not.  Many companies plans though do offer Roth 401(k) plans though, so if you’re looking to contribute to a Roth you often still can while earning your company’s match.

Hopefully, by now you know what type of retirement account is best for you.  If you’re looking for help on figuring out which funds in your retirement account you should go with, there’s a great article that discusses the pros and cons here: 

Evaluating your options in retirement plans

 

Please note that the above article represents my personal opinion only and is in no way meant to be construed as legal or financial advice.

 

 

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