With tax refunds and stimulus checks arriving, many of us have a small windfall of cash available and are thinking of saving it for the future.
And adding it to your retirement pot is not a bad idea if you can afford to think long term – putting it into an Individual Retirement Account, or IRA, is potentially a good idea. Overall, most people do not save enough for their retirement and anything you can do to boost your funds is going to help you in the long run.
But which type of IRA should you pick? There are two types of IRA – Traditional and Roth – and they have a very different approach to taxes which can make a big difference to your income later on.
Traditional IRAs were developed in the 1980s and offer a great incentive to save for retirement – you save tax-free.
Strictly speaking, an IRA is not actually a product but a line in the tax code – you are entitled to designate up to $6,000 a year (or $7,000 if aged 50 plus) of your gross rather than net income. This works as a deduction on your tax return.
This is great news – your fund will build much quicker as you are not sharing a portion with Uncle Sam. At least, not yet – tax will be payable on the money you eventually start to withdraw from your IRA in retirement.
But with a Roth IRA – named after former Delaware Senator William Roth who led the legislation to create them in 1997 – you can save for the future and opt to pay your share of taxes on the money today.
This means any money you withdraw in your retirement is tax-free, as you have already paid Uncle Sam.
So, depending on the vehicles you use for your IRA status, you could see substantial growth in your account balance over the years. For example, if you chose a higher risk market-based scheme to save in. In this case, a Roth would mean all that gain is tax-free as you paid it at the source.
But what was the thinking for a Roth in the first place if the idea is to encourage saving?
When the Traditional IRA was introduced in the early 1980s, two factors made them highly attractive. Both of these are still true, but to a lesser extent than they were. The first was the number of tax bands and the second was the rates of tax payable.
There were 15 income tax brackets, with the bands being much narrower and the upper bands having much higher tax rates applied to income. The assumption for most people is retirement. Their income would be less than when working, so the money withdrawn from the IRA would therefore be taxable but at a much lower rate than when you were earning and paying into the account initially. So pay the tax later when you pay less.
That is still true, but there are only seven bands today and the bands are much wider, with much lower rates at the higher levels so the tax saving is potentially much less than it was. If you have done very well with your savings, you may not even drop into a lower band at all.
But that still makes a Traditional IRA at least tax neutral, so why opt to pay the tax now in a Roth?
There are two key reasons why we may like to choose to pay tax now – the first is our lack of a time machine or a crystal ball. Put simply, we do not know what future tax rates will be. While they have fallen over the past four decades, there is nothing to say they will continue to fall or may even rise. No one can guarantee what a future President or Congress may do, especially if we are talking about tax rates in potentially another four decades. Many people think rates will have to rise to meet social security commitments as they currently stand. So if you opt to pay the tax now, you are covered against paying more tax should the rate rise in your retirement.
The second factor is in splitting the ticket – IRAs do not have to be one or the other. You can choose to split your savings between the two types, provided you do not exceed the total annual contributions. This means in the future, part of your income would be taxable and part pre-paid. That part would not count as income for tax purposes, meaning a lower declared income to be taxed.
As with all financial decisions, there are many other factors to consider and this is only a brief overview of the concepts – seek professional financial advice to make decisions as there are other rules and conditions attached to IRAs to take into account as well.