For many workers (especially those who are self-employed) who don’t have access to a 401(k) plan at their employer, IRAs (Individual Retirement Arrangements) remain a viable way to save for retirement. However, unlike the ease of payroll deduction at an employer offering a retirement plan, those who meet their own payroll must show more discipline to get the funds from their “business checking account” into their own IRA accounts. . (I am very familiar with this challenge.)
Most people who have taxable income and are over the age of 18 can set up an IRA. Once someone decides to fund their own retirement account, they should talk (or research on their own) with an advisor about which type of IRA makes the most sense for them: Traditional IRA or ROTH IRA.
Over the years, I’ve learned to simplify this “To Roth or Not to Roth” discussion with my clients and contacts by asking them a fairly simple question: “Do you want to pay tax on the seed and get the crop tax free? OR “Do you want to get a seed tax deduction and worry about future harvest taxes?”
Let me explain. With a ROTH IRA there is no current tax deduction, which means you would fund the account with after-tax dollars. With a traditional IRA, you enjoy a current tax deduction, so there’s an immediate benefit during the year you fund the account. With a ROTH IRA, the money grows tax-free, and when you withdraw it, it’s also tax-free. Plus, with ROTH IRAs, the IRS doesn’t require you to start withdrawing funds when you turn 70½. Finally, with a ROTH IRA, when you pass away, your heirs receive the funds tax-free.
With a traditional IRA, the tax savings you enjoy today are offset by the potential pain of paying taxes on the larger sum of money (assuming your investments grew over time) and the IRS will force you to start withdrawing the funds once that reaches 70 ½ – in other words, they want your tax dollars – and they will get them from you or your heirs. However, if you’re in a high tax bracket today and you assume you’ll be in a low tax bracket when you withdraw the funds, then a traditional IRA may still make sense.
Here’s a no-brainer: If you can set up ROTH for your children (or grandchildren) when they turn 18 (if they’re working), this is a great way to start their adult lives. Companies like Vanguard and Fidelity have good online platforms that you can use for these types of accounts. They have “target date funds” that can be a good way to “set it and forget it” for them to start investing. For our children, we also provide a dollar-for-dollar match for any contribution they make to their ROTH accounts throughout the year.
Today, since I primarily work with clients who have saved lump sums of money over 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 he can spend to pay taxes on traditional IRA funds that he does not plan to use for several years, a conversion to a ROTH IRA should be considered. By doing this, the IRA owner will pay taxes due today on the amount he converts and never again have to worry (or his heirs) about paying taxes on the growing amount of money converted. Also, when they turn 70½, the amount they converted will not have to be counted when calculating the amount of withdrawals the IRS requires them to take (Required Minimum Distributions – RMDs) and pay taxes.
Some final notes: There are income restrictions when it comes to taking 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 on withdrawing funds from a ROTH IRA, depending on whether you’re withdrawing earnings or your basis (the amount you contributed), and how old you are. Your tax advisor can advise you on these issues and/or there is plenty of information online that will explain these items.