Our goal is to have the most money possible in our retirement accounts. I’m talking about actual money, in hand, that we can spend to cover our bills in retirement. Therefore, we have to factor in taxes. We can’t avoid them. However, if we plan correctly, we can minimize the impact of taxes.
There are two types of IRAs. Traditional and Roth. The taxes on these two accounts work differently. Contributions to a traditional IRA are tax deductible, and taxes are paid when you take money out. Contrarily, contributions to Roth IRAs are not deductible. You pay tax on the money before you put it in. In exchange for paying your taxes this year, the government lets you take money out tax free when you are old enough. (A long list of restrictions for both IRAs exist. This is a simplified description.)
Why choose a Roth IRA over a Traditional IRA? Paying your taxes now may be beneficial. Most people imagine they will be making more money in the future. When I was working in a biotech laboratory, I used to think about how unsatisfactory my retirement would be if I had to live on less than I was making in my thirties. Instead, we plan on increasing our incomes and wealth throughout our careers. Even if a retiree makes 80% of their final pay, that amount will be more than they were making during the beginning stages of their career.
For these reasons, you should choose a Roth IRA if you are eligible for one. The income cut off limits are $132,000 for single filers and $194,000 for MFJ. Each year you have earned income less than the cutoff, but greater than $5,500, you can contribute $5,500. Contributing $5,500 may not sound like a lot, but let’s look at some calculations to see if we can have a significant amount saved by retirement. And remember, this amount will be tax free!
|$5,500/ yr||Age 30 to 67||Investment return = 0%||Value = $203,500|
Without earning any interest, we would have $203,500 if we start contributing at age 30 until full retirement age of 67. I started this calculation at age thirty to give you time to pay off your student loans and get a good job where you earn enough to put away $5,500 per year.
Now let’s change our return to a fairly conservative 5%.
|$5,500/ yr||Age 30 to 67||Investment return = 5%||Value= $586,902|
Not bad. Over half a million dollars.
Now since this is a tax free account that we can’t take the money out of until we are 55 without penalty, let’s get aggressive with the investments and plan for an 8% return.
|$5,500/ yr||Age 30 to 67||Investment return = 8%||Value= $1,206,237|
Check out that result! (This number will actually be higher than 1.2 million because the contribution limit will not remain at $5,500 for the next 37 years. It has increased at 4% per year since 2002 when it was $3,000.)
This shows us that it is possible to accumulate over 1 million dollars tax free for your retirement! And this is only in your Roth IRA. You will also have your 401(k) and other investment accounts.
If you would like to talk to me about this or other investing ideas, call us at (760) 651-6315.