There’s an ancient proverb that says the best time to plant a tree was 20 years ago and the
second-best time is now. If you’re trying to save money for retirement, it’s a good idea to heed that same advice. While growing a tree and building a nest egg may both start with planting a seed, getting to a financially secure place for retirement does require a bit more strategy, especially when it comes to IRAs and 401ks.
That’s where Roth IRAs and 401ks come into play. Many people are already enrolled in
traditional 401ks through their workplace. But Roth accounts offer an alternative, along with
many advantages in the way of taxation and differentiation. So let’s walk through the Roth-style accounts and learn what exactly they can do for you and your money.
What is a Roth IRA?
A Roth IRA is an individual retirement account that lets you use after-tax contributions, as
opposed to pre-tax contributions, to grow your wealth. Simply put, it means you aren’t taxed
when it comes time to pull your money out of the account.
There are many advantages to the Roth-style strategy, including:
- Tax-free investment growth
- Easy, tax-free withdrawals
- No minimum distribution requirements
- Tax-free benefits for your beneficiaries
Of course, these benefits come with certain regulations from the IRS. These include an age
requirement of 59.5 years to collect distributions without penalty, and a stipulation that your
account must be open for at least five years before you withdraw funds without penalty.
Additionally, income limits regulate contributions, although there are ways to sidestep this. All in all, it’s helpful to think of Roth accounts and traditional retirement accounts as two sides of the same coin.
Traditional IRA vs. Roth IRA
When it comes down to it, the largest difference between traditional and Roth IRAs is when
your money is taxed—traditional is taxed when you withdraw funds, Roth is taxed when you
deposit funds. Because of this, most people actually save more money in the long run with a
Roth IRA or 401k than a traditional one.
Consider this example: You save 10% of your income in a Traditional 401k. As you work, you save 10% of your income and eventually grow the account to $1M. With a traditional 401k, not all of that $1M is truly yours, as you owe 15-30% in taxes. With a Roth 401k, you still save 10% of your income and when it grows to $1M, all of that cash is 100% yours, tax-free.
Despite the identical account balances, you are left with more usable money with the Roth account because they are taxed differently.
A Young Person’s Retirement Game
A Roth IRA is especially beneficial to those just starting to invest in retirement. That’s because they have plenty of time for their investment to grow. Roth accounts also are beneficial from a tax perspective, allowing people to maximize their potential tax savings by paying tax on the“seed” of their investment, not the fully actualized and much larger “crop”. This makes it one of the most stress-free ways to save for retirement, as all of the money that comes from these types of accounts is tax-free.
Time is the key ingredient here, and it’s what makes these accounts so worthwhile for young
people. Time allows money to compound in your account, which eventually snowballs into a
large sum over the years. With consistent growth, your Roth account could turn $100 into $500 or more by the time you retire. And when you start dealing with thousands of dollars, that money grows exponentially as time goes on.
Taxes: The Other Side of the Diversification Coin
Many people know how important it is to invest in a variety of assets in order to build a strong financial portfolio. However, many people don’t take the same advice when it comes to tax strategy, and it shows. Taxes can be one of the biggest expenses in a person’s life, especially around retirement age. One of the easiest ways to soften the blow is to have investments that are taxed in different ways.
For example, I have several clients that started saving for retirement in the ‘80s when tax-
deferred investment accounts and traditional 401ks were all the rage. The thought was that it
was better to pay taxes down the road instead of right now. While this was a good idea relative to a taxable brokerage account, it doesn’t make the most sense for retirement planning. So, now these clients are forced to take distributions from their retirement accounts that are taxed at ordinary income levels which can, in turn, increase the taxable income, increase Medicare premiums, and even reduce their Social Security.
With a smarter tax strategy, those clients could avoid taking huge tax hits by:
- Investing higher growth investments in retirement accounts like Roths
- Using annuities as a tax-efficient vehicle
- Incorporating real estate into their investment strategy
Much like planting a tree, growing your retirement savings takes a little foresight, but years
down the road, the actions you take today can provide great benefits tomorrow. Roth IRAs and 401ks are a great addition to any financial strategy, as they provide much-needed tax
diversification as well as many benefits when it comes time for distributions.
If you’re interested in learning more about Roth accounts or if you want to start diversifying
your tax strategy, take advantage of Four Points’ free one-on-one consultation. We’ll
personalize your financial strategy and set you down the path toward financial freedom. And as always, feel free to reach out to me and bring any questions you may have on how to get ahead on your financial goals.