With so much speculation on long-term tax rates, it’s hard to figure out if a Roth IRA or Traditional IRA makes more sense
The saying goes, “nothing is certain in life but death and taxes”. Its inevitable that you will have to pay taxes, but you don’t need to pay more than is necessary! And that takes careful financial planning, especially for real estate agents.
I want to discuss terms that you have likely heard of, but may not fully grasp. These are the retirement plan savings vehicles of a Traditional IRA and a Roth IRA.
This is an account that you set up with an investment company that will allow you to deposit up to $6,000 in a given year that will avoid income taxes. If you are 50 years old and over, you are allowed to add an additional $1,000 with tax avoidance.
Once the funds are in the account, you can invest that money into stocks or index funds and the potential growth remains untaxed. However, at retirement, you are required to pay your ordinary income tax rate on any funds taken out of the IRA.
So, tax benefit at contribution, but not at withdrawal.
In this instance, the opposite occurs. You set up a Roth IRA in the same fashion, at an investment company. You, again, can contribute up to $6,000 into the account with AFTER-Tax money. Meaning, this does not avoid or reduce your tax in the year of contribution. If you are 50 years old and over, you still can still contribute an additional $1,000.
The big difference is that the funds can potentially grow without taxation and then can be withdrawn at retirement without ordinary income tax or capital gains tax.
So, no tax benefit at contribute, but major tax benefit at withdrawal.
Now the question becomes, is it better to utilize a Roth IRA or Traditional IRA? It’s hard to give a definitive answer with so many factors at play. However, it really depends on 2 questions:
1. Do you think that your tax rate will be higher or lower in the future (i.e. At retirement)?
2. Does your income fluctuate from year to year?
You might be thinking that one may better serve you than another. Or that you should consider diversifying by splitting between using both the Traditional IRA and a Roth IRA every year.
However, as the recent Michael Kitces article and study finds, neither of those strategies works the best.
In fact, the best strategy is Roth optimization. Instead of arbitrarily guessing the best approach, Roth optimization is a strategy where you would utilize the right vehicle for your current household situation in each year.
As the picture depicts, life isn’t a straight line. So, in year’s where income is lower than usual, you would want to contribution or convert funds to a Roth IRA. In years where income is high and you are approaching a higher tax bracket, a Traditional IRA would be a better strategy.
This requires a bit more planning throughout the year as life unfolds, so its’ critical to have a financial planner that’s proactively working with you throughout the year to help you reduce taxes and increase long-term wealth.
The decision of pre-tax or after-tax ebbs and flows…like life. You should be aware of your personal situation. Update your financial planner and tax accountant. Then take the strategy that is going to best help you and your family reach your financial goals.
If this all sounds like too much work, well, that’s what a proactive financial planner is for. If you want to know what is the best right strategy for you this year, I’m happy to offer a complimentary financial plan for real estate professionals with actionable next steps.
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Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.