Saving for retirement and securing a healthy financial future is one of the essential components of personal finance.
When it comes to saving for retirements, the most popular vehicles are employer-sponsored retirement plans, like 401(k)s and Individual Retirement Accounts (IRAs).
IRAs seem like straightforward accounts where you contribute the yearly maximum, and you wait for the magic of compound interest to do its work and grow your investment over time.
There are two primary types of IRA, traditional (pre-tax) and Roth (post-tax), and the common conception is that you contribute to a Roth IRA when you are younger to take advantage of the tax savings. You switch to a traditional IRA later on as your income increases.
Today, we will describe how IRAs work and how combining traditional, Roth, and SEP-retirement accounts can provide the highest return on your savings.
IRAs
Traditional IRAs are considered pre-tax vehicles, which means your contributions and capital gains are not taxed until you begin withdrawing money from your account during retirement.
The advantage of deferring taxes until later is that you can initially contribute a more considerable amount of pre-tax dollars, leading to higher compounding.
Traditional IRAs have an annual 2023 contribution limit of $6,500 if you are under 50 years old and $7,500 if you are 50 or older to help you “catch up.”
Example: If you are in the 30% tax bracket and you put $6,500 in, your tax savings for that year would be $1,950. Said another way, instead of investing $4,550 in a brokerage account, you would be able to invest $6,500!
Who should consider contributing to a Traditional IRA?
Traditional IRA plans are best for individuals and families in a higher tax bracket who are not eligible to contribute to a qualified plan. Additionally, if you live in a higher tax state that does not tax retirement income, you should consider contributing to a Traditional account instead of a Roth IRA.
Roth
Post-tax contributions fund Roth IRAs. The money invested through a Roth account is already taxed, so all gains and withdrawals during retirement are tax-free.
This is a significant tax advantage because by essentially prepaying the taxes at a lower rate, you can potentially save thousands of dollars over the long run.
Roth IRAs have the same 2023 contribution limits as the Traditional IRA of $6,500 if you are under 50 years old and $7,500 if you are 50 or older. However, there is an income limit for contributions.
Who should consider contributing to a Roth IRA?
If you have money in a taxable investment account or extra cash in a savings/checking account and are eligible to contribute, you should consider a Roth contribution.
The motivation for this after-tax account stems from the assumption that you will likely retire in a higher tax bracket than you currently are in (combined federal and state income taxes).
Even if you cannot contribute to a Roth IRA because you do not meet the income requirements, they are an excellent vehicle for financial gifts to your children and grandchildren. If you make a financial gift as a Roth IRA contribution for your family member, all of the returns will grow tax-free, which can be used to pay for education expenses or a down payment on their first home.
If you live in a state with a significant state income tax that doesn’t tax retirement income such as Illinois, you should consider making a traditional IRA contribution instead and then convert it to Roth during retirement as this would prevent you from having to pay state income tax on those funds.
Simplified Employee Pension (SEP)
The SEP account is an additional option for building retirement savings.
While SEP accounts are employer generated, business owners, freelancers, and self-employed professionals can contribute to a SEP account.
This can potentially turbocharge your retirement savings because you can contribute to a Roth IRA and a SEP account (assuming you qualify to contribute to a Roth IRA account).
* It’s important to note that SEP account earnings grow tax-deferred similar to an IRA/401k
For example, if you contribute the $6,500 maximum to a Roth IRA, you can still contribute up to 25% of your compensation, or $58,000 (whichever is the lower amount)
For self-employed professionals, the SEP contribution limit is 20% of the business’s adjusted net income.
However, if you want to save more than 20%, you may consider an Individual 401k where you can save $19,500 + 20% of your business income.
Who should consider contributing to a SEP?
Small business owners and self-employed individuals stand to gain the most benefits from a SEP account.
Tax Differences*
- Traditional, SEP, and 401k accounts are all tax-deferred, which means you don’t pay taxes on the contributions you make, but you will pay taxes when you withdraw funds. (some states don’t tax retirement income distributions from these accounts, so traditional accounts may make better financial sense in certain situations)
- Roth IRAs and Roth 401k are both post-tax vehicles so all of the returns over the account’s life grow tax-free.
Deciding which is right for you
Hopefully, you can see that there are a multitude of powerful retirement tools at your disposal when you set up your accounts.
While you can implement a “set it and forget it strategy” with an IRA, taking the time to understand how traditional, Roth, and SEP accounts can optimize your earnings and tax savings can lead to robust returns over the long-haul.
If you have any questions about managing your retirement accounts or want to learn more about investing in general, please schedule a call with us – we would love to chat.
