Up until about 10 years ago, there was one type of IRA, the traditional IRA which was deducted from your taxable income, grows tax deferred, and upon withdrawal, is taxed at whatever rate you find yourself. Its cousin, the Roth IRA is the mirror image, the money you put in is after tax money, but you never pay tax again on it, at least according to current rules. So the distinction can be summed up as our Uncle Sam saying, “You can pay me now, or pay me later.”
Three Approaches to Minimizing Your Taxes with Tradition IRA and Roth IRA
Now, it’s easy to understand what tax bracket you are in now, or at least where you were on your last year tax return. Take a look at your taxable income toward the end of the return, and take a peek at Fairmark.com, and from that table, you’ll know your rate now. The tough part is to forecast your tax rate at withdrawal. The truth is, unless you are close to retiring, you can’t know, and even if you are, our friends in congress are able to change things just when you think you have your plan in place.
So what’s an investor to do? There are three approaches you can take, each has its advantage.
1. Tax Diversification
The first is Tax Diversification. Mike Piper does a great job discussing this method.
2. Full Pre-Tax Savings (Traditional IRA or 401k)
Next, let’s discuss the concept of going full pre-tax.
How much would you need to save for this to be the ‘wrong’ choice?
Today, a retired couple is in the 15% bracket for taxable income up to (but not over) $67,900. Taxable. They also have a standard deduction of $11,400 as well as their two exemptions, $3,650 each. The grand total is $86,600. To generate this much income, even if you are withdrawing 5% per year (most advisors suggest 4% as the maximum withdrawal each year) it would take over $1.7 million.
Given the current average retiree’s account is nowhere near this number, this strategy actually has some appeal. On your 40 year journey to retirement, the road is rarely without bumps. You can take advantage of periods of unemployment or underemployment to convert some money to a Roth IRA, and pay taxes in the year your bracket drops. If disabled, you can take it out without penalty, using your standard deduction and exemption to have some tax free income.
3. Roth IRA Savings
Last is a bit of a different approach. If you find that you are in the 10% or 15% bracket, more than half of us are, you should choose the Roth IRA path.
Optimize Your Tax Savings By Living In The 15% Bracket
There’s a good chance that by just paying attention to your finances and reading this, you are not average. You are above average in both motivation and intelligence. Thus, the chance that you earn your way right into the 25% bracket and beyond are higher for you than the data suggests. Whether it’s five or ten years from now, or sooner than that, you will find yourself in the 25% bracket. At that point choose pre-tax savings.
When you right at the edge, it can be tricky, using a combination of both Pre-Tax IRA along with Roth to get your taxable income right at the edge of the bracket, so the next dollar of income would be taxed at 25%, but the last was taxed at 15%. You may find that when you buy your first home, the combination of mortgage interest, property tax, and state income tax is enough to put you back in the 15% bracket. Back to a Roth for you.
If you are well within the 15% bracket, you could also use Roth IRA Conversion, where you take some pre-tax IRA money, and pay the tax, turning that money into Roth IRA dollars.
See where I’m going with this? There are a large number of people for whom this is the optimum strategy. This will have you “living in the 15% bracket” and it’s worth the time to understand your tax bracket to get the most benefit from these retirement accounts.
IRA Phase Out Limits
Before we finish this discussion, it’s important to understand the income thresholds that might limit your options. If you are married, the phase out for Traditional IRA contributions is $89,000-$109,000, for Roth, it’s $166,000-$176,000. If you are single, the phase out for Traditional IRA contributions is $55,000-$65,000 for Roth, it’s $105,000-$120,000. So for those who are above the limit to deposit to a traditional, your best choice is to go with the Roth. Above the next phaseout range, where even the Roth is unavailable to you, you can choose to deposit to a IRA, with post tax money and perhaps convert to Roth, if you choose to, starting in 2010*. Take advantage of the options available to you.
* Please note that there is a special Roth IRA conversion event in 2010 (see comments below for clarification).