For many workers (especially those that are self-employed) that do not have access to a 401(k) plan at their employer – IRAs (Individual Retirement Arrangements) are nevertheless a viable way to save for retirement. However – unlike the ease of payroll deduction at an employer that offers a retirement plan – those that are meet their own payroll must show more discipline in getting the funds from their “business checking account” to their own IRAs. (I am very familiar with this challenge.)
Most people that have taxable income and are over the age of 18 can establish an IRA. Once someone decides to fund their own retirement account they should have a discussion (or research it on their own) with an advisor as to which kind of IRA makes the most sense for them – Traditional IRA or ROTH IRA.
Over the years I have learned to simplify this discussion of “To ROTH or Not To Roth” with my clients and contacts by asking a fairly simple question: “Do you want to pay taxes on the seed and get the harvest tax-free? Or “Do you want to get a tax deduction for the seed and worry about the taxes on the harvest down the road?”
Let me explain. With a ROTH IRA there is no current tax deduction – meaning that you would fund the account with after-tax dollars. With a Traditional IRA you enjoy a current tax deduction so there is an immediate assistance during the year you fund the account. With a ROTH IRA the money grows tax-free and when you withdrawal it – it is also tax free. In addition – with ROTH IRAs the IRS does not force you to begin to withdrawal the funds when you reach the age of 70 ½. Finally – with a ROTH IRA – when you pass on – your heirs receive the funds income tax free.
With a Traditional IRA the tax savings that you enjoy today are offset by the possible pain of paying tax on the larger sum of money (assuming that your investments grew over time) and the IRS will force you to start to withdraw the funds once you hit 70 ½ – in other words they want their tax dollars – and they will get them either from you or from your heirs. However – if you are in a high tax bracket today and assume that you will be in a low tax bracket when you withdrawal the funds – then a Traditional IRA may nevertheless make sense.
Here’s one no-brainer – if you can establish ROTHs for your children (or grandchildren) when they reach the age of 18 (if they are working) – this is a great way to start them off in their adult lives. Companies like Vanguard and Fidelity have good online platforms that you can utilize for these types of accounts. They have “Target Dated Funds” which may be good “set it and forget it” way for them to start to invest. For our children – we also provide a dollar for dollar match for any contributions they make into their ROTH accounts throughout the year.
Today – since I work mainly with clients that have saved lump sums of money throughout their working lives – I often have the discussion about moving money from Traditional IRAs to ROTH IRAs – which is called “Conversion”. In short – if a person has non-retirement funds that they can use to pay the taxes on Traditional IRA funds that they are not planning on using for several years – a conversion to a ROTH IRA should be considered. By doing this the IRA owner will pay the taxes due today on the amount they transform and not ever again have to worry (or their heirs) about paying taxes on the growing pot of converted money. In addition – when they reach age 70 ½ – the amount that they converted will not have to be counted when calculating the amount of withdrawals that the IRS forces them to take (Required Minimum Distributions – RMDs) and pay taxes on.
A few final notes – there are income restrictions when it comes to getting a tax deduction for a Traditional IRA. There are also income restrictions that will affect your ability to contribute to a ROTH IRA – these restrictions vary depending on how you file your taxes – single, married, etc. There are also some restrictions to withdrawing funds from a ROTH IRA – depending on if you are withdrawing the earnings or your basis (the amount you contributed) – and depending on what age you are. Your tax advisor can advise you on these issues and/or there is plenty of information online that will explain these items.