Are you saving for retirement? If so, then you already know there are plenty of ways to do so. Some of them are mutually exclusive. Others aren’t.
No matter which retirement savings choices you make, however, your ultimate goal is most likely the same as everyone else’s. That’s maximizing the size of your eventual nest egg.
The funny thing is, your optimized savings strategy may look considerably different than many other people’s. I know mine does. Whereas most investors prefer a Roth IRA to a traditional IRA, for me, the traditional IRA makes much more sense. Here’s why.
Roth IRA vs. traditional IRA
If you’re not familiar with the difference between the two types of individual retirement accounts, it’s not complicated. Contributions to traditional IRAs (often called contributory IRAs) are typically tax-deductible for the year in which they’re made — you’ll simply owe taxes on this money as it’s withdrawn from these accounts. With Roth IRAs, conversely, there’s no tax break when putting money into these types of accounts, but withdrawals from Roth IRAs are tax-free.
Of course, both kinds of accounts are allowed to grow without incurring any tax liabilities as they do.
There are limitations. As it stands right now, people under the age of 50 can only contribute a maximum of $7,000 in 2024 to these self-directed retirement accounts, while people aged 50 and over can deposit a total of up to $8,000 to these two types of IRAs. You can also mix and match these capped contributions to both kinds of accounts in any given year.
The tax-deductibility of contributions to traditional IRAs might be partially or wholly negated if you also participate in a work-based retirement plan like a 401(k), while high-earning individuals and their spouses may not be allowed to make full or even partial contributions to a Roth IRA. For the average individual or household, however, most of these limitations don’t apply.
Still, the question remains … why am I in the minority with my preference for funding a traditional IRA rather than a Roth IRA? The answer is simple: I’m just trying to minimize my total tax liability at a time when I’m subject to the most taxation.
Reasons to skip the Roth and fund a traditional IRA instead
I’m a pretty average American. Like most people, I’m making more money now by working than I expect to be earning from my investments once I retire. And I’m OK with that. All my major debts (including my mortgage) will be paid off by then. The rule of thumb is that you’ll only need to replace about 80% of your work-based income in retirement.
Don’t get me wrong. I’d love for future withdrawals from my IRA to be tax-free events. But my tax deductions for traditional IRA contributions do me considerably more good now than tax-free withdrawals would then. I’m fully expecting my retirement income to lower my top tax bracket rate, in fact.
That being said, there are some very specific upsides that make this strategy the right one for me.
While I currently live in a state that taxes withdrawals from retirement accounts as income, that won’t be the case then. My long-term plan includes moving to a state without any state-based income tax. While this won’t avoid federal taxes on this future income, this move is going to save me a fair amount of money in retirement.
I’m also one of those oddballs who expects Social Security to still be around when the time comes for me to claim benefits.
Granted, I may be unduly hopeful regarding Social Security’s future. See, being self-employed for most of my adult life, I’ve actually made a point of maximizing my reported income so I could in turn make larger income-dependent contributions to self-employment retirement accounts like SEP-IRAs and SIMPLE IRAs. This has (largely by sheer luck) set up healthy Social Security retirement payments that also won’t be taxed by the state where I intend to live once I claim these benefits.
I’m not unrealistic about this program’s future. I’m actually anticipating the reduced payouts projected for Social Security by the mid-2030s. This will shrink benefits by about one-fourth of their current levels. But allowing the program to completely collapse is politically problematic enough that federal politicians will take some sort of action to prevent it. That’s why I’m looking for legislation that will further tax the nation’s very highest earners to keep the program funded.
However it happens, although any future withdrawals from my traditional IRA will be federally taxable as ordinary income at regular income tax rates, I also know at least some of my Social Security retirement income isn’t subject to any taxation at all.
Finally (and perhaps best of all), I’ve always got the choice of converting some or all of my contributory IRA to a Roth IRA in the future. This is usually a taxable event for the year it happens. You’re not required to use money from the retirement account in question to pay this tax bill, though. If you’ve got enough cash saved up outside of the retirement account to cover the tax consequence of converting to a Roth, that’s an option too.
Converting traditional IRAs to Roth IRAs has its downsides. Chief among them is the fact that once it’s done, it can’t be undone. But one clear upside is that I can make this conversion at a point in time when the market’s down, thus minimizing my tax liability stemming from the decision.
Just make sure it makes sense for you
Again, my plan may still not necessarily be the right one for you.
As a reminder, I’m pretty certain I’m earning more money now than I’ll be collecting from my investments then. Your situation may be different — you may be making more money in retirement than you are right now. I’m also betting my current tax rates and subsequent tax liabilities are higher at this time than they’ll be then, but this might end up not being the case either. Tax brackets and tax rates are always changing, after all.
Given what I know right now and what can’t be known yet, however, I’ll still choose a traditional IRA over a Roth individual retirement account. I suspect lots of other investors would as well if they did some careful number-crunching.
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I Absolutely Prefer a Traditional IRA to a Roth IRA for Retirement Savings. Here’s Why. was originally published by The Motley Fool
Source: finance.yahoo.com