Traditional IRA vs Roth IRA – Minimizing Taxes by Investing in the Right AccountsSubmitted by Reby Advisors | Certified Financial Planners | Danbury, CT on March 31st, 2017
If there’s one area of financial planning that can be confusing even for savvy investors, it’s determining which types of accounts to invest in to minimize your taxes. Your 401(k) or traditional IRA investments reduce your income taxes while you are working by allowing you to invest with pre-tax income. However, withdrawals from these accounts get taxed as ordinary income in retirement. The Roth IRA, on the other hand, offers no immediate tax advantages, but withdrawals are tax free.
When should you invest in a pre-tax 401(k) or Traditional IRA vs a Roth IRA?
The rule of thumb is that the younger you are or the lower your salary, the more sense it makes to contribute to a Roth account. The pre-tax Traditional IRA or 401(k) becomes more attractive as you approach retirement and your income gets higher. The graphic below from JP Morgan illustrates this nicely:
The graphic above is for illustrative purposes only and does not represent advice.
How to Balance Contributions at Different Life Stages
Let’s review a few fictional but realistic scenario to help clarify:
Roth Advantages Early in Your Working Career
“Carol” launched her working career as a Marketing Assistant at age 21, earning an entry-level salary. Because she’s ambitious and plans to advance to bigger and better things, she is currently earning what she expects to be the lowest salary of her career. She’s also paying the lowest effective tax rate of her working life. Her company does not offer any matching contribution, but she’s smart and wants to start investing for retirement anyway.
Her advisor may recommend a Roth instead of a pre-tax IRA or 401(k), even though there is no immediate tax advantage to investing in the Roth. He explains that because her current tax rate is low, the advantage of investing pre-tax is minimal; in retirement, many years from now, she’ll likely be in a higher tax bracket and will enjoy greater tax savings from the tax-free withdrawals her Roth allows.
Mid Career Balance
As Carol climbs the corporate ladder and becomes a Marketing Director in her early 40s, her income increases, she enters a higher tax bracket, and each additional dollar she earns gets taxed at a higher rate than when she was a Marketing Assistant with a lower salary. Now, her advisor sees greater tax advantages to investing in a 401(k) or Traditional IRA. When she invests $10,000 per year pre-tax, it saves her $2,800 in her current-year taxes, because she’s in the 28% tax bracket. If she’s a diligent saver and investor, she may still contribute to her Roth IRA, with the goal of having a 50/50 balance in her accounts at retirement.
Finishing Strong with Pre-Tax Investments as Retirement Nears
Carol reaches the pinnacle of her career at age 55. As Chief Marketing Officer, much of her salary and bonus gets taxed at the highest rate of 39.6%. Investing $10,000 in a 401(k) or Traditional IRA saves her $3,960 in her current year taxes, outweighing the likely future tax benefit of additional Roth contributions.
The story of Carol certaintly does not represent everyone, and is not intended as advice for any specific situation. Different circumstances, personal goals, and other variables may impact the advice we may give on this topic.
If you would like personal advice on how to save, invest, and ultimately withdraw from your accounts in a way that minimizes your taxes, give us a call at (203) 790-4949 or send us an email at email@example.com!
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Roy, S.K., Carson, S., & Razkallah, L. (n.d). Guide to Retirement. Retrieved from