Many financial advisors and accountants suggest contributing as much money as possible to your workplace 401k or traditional IRA. The money put into these retirement vehicles reduces taxable income and saves taxes today. For many people, funding a Roth IRA may be a better strategy.
Traditional IRAs, 401ks, and Roth IRAs all provide generous tax breaks. The difference is when you get to claim the tax breaks. With traditional IRAs and 401ks, taxes are avoided when the contribution is made. With Roth IRAs, taxes are avoided when the money is taken out in retirement.
The major factor in deciding whether to take the tax break now or later comes down to whether you expect your income tax rate in retirement to be higher or lower than what you currently pay. Most people expect to be in a lower tax bracket in retirement so they take the tax break today. I suggest you take a harder look at this assumption.
For many of my clients, gross income decreases in retirement, but taxable income does not. Sure you are making less money, but you have fewer deductions because the kids are out of the paid-off house (hopefully), and you are no longer setting aside money for retirement. Your taxable income, therefore, doesn’t change much from when you were working. Furthermore, given today’s large deficits and historically low federal tax rates, it is likely that income tax rates will rise in the future.
Traditional IRAs and traditional 401ks force you to start taking required minimum distributions (RMDs) at age 70 ½. These RMDs can cause serious tax pain. For example, I had a client who sold a piece of property last year for a large gain and consequently didn’t need his RMD in order to live. He, however, was forced to take the money and it ended up being taxed at the highest federal and state levels. He lost nearly half of the RMD to taxes.
Roth IRAs, on the other hand, do not require withdrawals during your lifetime. This gives you tremendous flexibility in tax and estate planning. If you don’t need the money in one year then you don’t need to touch it. You can allow the money to grow for your heirs. Unlike beneficiaries of traditional IRAs or 401ks, beneficiaries of Roth IRAs don’t owe income tax on withdrawals and can stretch out distributions over many years.
The Roth IRA is a powerful retirement vehicle that deserves your consideration. In exchange for giving up an upfront tax deduction, you get tremendous flexibility on the back end. The above is a summation of complex tax law. Please check with your tax professional before making a decision. Our CPAs at Milliken, Perkins, and Brunelle are available to assist you any time of year.