Everyone knows saving for retirement is important. Knowing the best options and how to get started isn’t always as obvious. For example, do the tax benefits of Roth IRAs mean they should be part of your retirement plan? Or are traditional retirement accounts a better fit? Here are some retirement account basics to help you understand.
There are two main retirement vehicle categories:
- Tax-deferred accounts (traditional IRA & 401k savings) allow you to pay no income tax on the retirement savings today; later, all withdrawals (annual deferral and compound growth) will be taxed at future marginal income-tax rates.
- Tax-free accounts (Roth IRA or Roth 401k) require you to pay taxes now on the savings, but not on any withdrawals in retirement. In 2020 you can contribute $6,000 to a Roth IRA if you have earned income, and you are below the $124,000 to $139,000 phase out range.
Does the difference really matter right now? Current income tax rates are likely the lowest they will be for a decade; and, they’re set to revert to higher rates in 2026. (See chart below.) They could go even higher in the future.
If you’re currently a single 30-year-old grossing $52,000, your tax rate is 12 percent after your standard deduction of $12,400. In 2026, the rate for the same income will be 15 percent. But, odds are you’ll be making more. Let’s say your income is $150,000 in 20 years; you’ll be in the 28 percent income tax bracket. That’s more than double your rate today. Thus, paying taxes on the deferral now through a Roth can mean significant tax savings in the long-run. Start investing as soon as you have earned income – say in your teens or 20s – and you’ll benefit from 40 years of compound interest. Talk to the young people in your life about the importance of early investing. Or, ask your financial planner to chat with them.
Those at or near retirement age should look at how Required Minimum Distributions (RMDs) will impact their income taxes. Starting in 2021, RMDs must begin the year you turn 72. It might make sense to take early distributions or make Roth IRA conversions to use up the remaining amounts at the lower tax rates. To watch a brief video in which Mike explains RMDs, click here.