Grab a Cool $100K with a Roth IRA

I have spent a lot of time over the last few years thinking about ways to maximize my savings and minimize my tax liability. After much reading and talking to others, I think I understand how a Roth IRA can help you and me with savings and taxes. So now it is time to share my understanding with you in this article, which is the first in a series of articles about Roth IRAs.

Disclaimer

I am not a tax professional. Please consult one before taking any action on the ideas presented below.

Show me the money – Rod Tidwell

As expressed so well in Jerry Maguire, in the end, it’s all about the money. Specifically, how much money you will have in retirement AFTER you have paid your taxes. The amount available depends on how much you choose to save, how well you invest your savings, and when you pay the tax on your savings. Today, we are focusing on the “when”.

I’ll gladly pay you Tuesday – J. Wellington Wimpy

Individual Retirement Accounts (IRAs) are a great way to stash money away for retirement because the assets inside them are not taxed even if you buy or sell them repeatedly. This allows you to invest your money as you like and let it grow without worrying about paying taxes now on the money that is invested.

You can pay me now or you can pay me later – The FRAM Mechanic

There are two types of IRAs:

• A Roth IRA, which is the “pay me now” type of IRA. A Roth IRA lets you pay the tax upfront and withdraw the money including any gain when you retire tax free. There are even ways to get your original contribution out tax free before you retire, but that will limit the money you have later, so I won’t cover that here.

• A Traditional IRA, which is the “pay me later” type of IRA. In this case, you contribute money before you pay income tax. Like a Roth IRA, you can invest the money inside the account any way you like without paying any taxes on the money contributed. Unlike the Roth, you pay tax on the money when you withdraw it.

Assuming you are always in the same tax bracket, there isn’t any difference on the total money you get out. Here is an example where you contribute $200 per month from age 22 to 67, earning 8% per year on your investment and you start taking the money out at 72.

This chart assumes you are in the 22% tax bracket for your entire life.

Although the Traditional IRA grows faster, it all evens out when its time to pay the piper.

What goes up doesn’t always come down

Newton’s Law of Gravity doesn’t apply to finance. If you do well in your career, you are probably saving a lot more than $200 per month. Your nest egg could be bigger than $1M. As you take the Required Minimum Distributions (RMDs) from a Traditional IRA, your money may continue to grow so you get pushed into the 32% tax bracket and start forking over some real dough in taxes and things can get ugly.

If you have some of your money in a Roth IRA, you don’t pay the high tax when you withdraw it (because you paid the tax before you put the money into the IRA). There are also no RMDs, so your savings can continue to grow tax free for your lifetime and beyond.

Change is the only constant – Heraclitus

The thing is, you won’t always be in the 22% bracket. As you grow older and become more experienced, you will hopefully become better paid and you will move into a higher tax bracket.

What if you contribute to a Roth IRA when your tax rate is low and a Traditional IRA when your tax rate is high? Let’s call this a Blended Approach.

Here is an example where you are in a 12% bracket from age 22-26, 22% bracket from age 27-31, 24% from age 31-61, and 22% from age 62-66 (you work less hard for a while before you retire at 67). Then you stay in the 24% range for retirement.

When is time to withdraw funds for your retirement expenses, withdrawing from both your Traditional IRA and your Roth IRA can provide the most money while minimizing your tax bite.

The Blended Approach yields $100K more in retirement. Who couldn’t use that?

Catch-22

What is that you say? You’re not 22 and can’t afford a time machine?

That’s OK, there is still time to help yourself. While you are still earning money, think about what expenses you will have in retirement. Also think about how much you will be forced to withdraw because of RMDs. If that means you will be in the same or a higher tax bracket in retirement, put your money into a Roth IRA this year. If it means you will be in a lower tax bracket later, put your money into a Traditional IRA. The same logic applies if you are contributing to either type of 401k.

Also, even if you’re not a millenial, you problem know one who could use a little guidance on an approach.

Down the Road

In addition to contributions, you can also convert funds from a Traditional IRA to a Roth IRA in any given year. You just have to pay the tax on the funds you move. If your tax bracket is going to be higher later, this can make sense. In the next article I’ll discuss more about Roth conversions.

What is your IRA approach?