What is the Best Way to Save for Retirement?
I get asked that question frequently, and it’s an important question. Consider the person who is determined to set aside for retirement and disciplines him or herself to continue investing hard earned money all throughout their career. At the time they wish to retire, they discover that they had not accumulated enough, suffered an enormous (and unnecessary) loss, or that they are possibly facing a huge tax liability.
I’m certain this individual would much rather have discovered they were on “the wrong path” earlier than later. If you have a reasonable amount of time prior to your desired retirement (reasonable being ten years or more), good news! There’s time to plan effectively.
Let’s first look at the tax treatment of your future income for retirement. What do you have, or will have, set up thus far? Do you have an IRA? A 491(k), 493(b), 457, TSA or TSP? Are you scratching your head wondering what all those numbers and acronyms mean? All these retirement vehicles (some being company or Government sponsored plans), as well as Simple and SEP IRAs, are 100% taxable when accessed at retirement. While that may seem normal, it doesn’t have to be.
Picture yourself retired. Traditionally, your children are adults now, so you lose the Child Tax Credit. Your home may be paid off, or close to it, so you lose your mortgage interest to deduct on your Tax Return; the income you are going to draw is reported as Taxable Income. If you were to withdraw $4,000 a month from your IRA or 401(k), for example, that would be $48,000 reported as income for the year, which puts you in the 25% Federal Tax Bracket if you file Single, or 15% if filing Married-Joint.
The hypothetical tax liability for the Single in this scenario would be $7,793.75 and for the Married Couple $6,277.50. This also assumes no other sources of income. Other sources, such as Social Security, will also be reported, in part, as Taxable Income, increasing the tax burden.
You can see that, in retirement, Income taxes can potentially be one of your largest expenses. Now, given the chance, would you prefer to keep all of the income you draw for retirement, paying no taxes on that income? It’s possible, but now is the time to plan for that, not at retirement.
To achieve tax-free income later in life, I recommend the most under-utilized vehicle available to Income Earners- the Roth IRA. Money is placed in a Roth IRA after income taxes have been paid. You, the Investor, choose what investments you wish to hold within the Roth IRA. Then the magic happens. All of the growth over time, plus the money you’ve contributed, is accessible tax-free! Note that the intention is for funds to accumulate and be accessed at retirement. However, if needed, money can be accessed tax-free providing you have held those funds in the Roth IRA for at least five years.
There are limits and restrictions, of course. If the combined Adjusted Gross income of a couple filing “Married-Joint” is $183,000 or less (as of 2015), then each wage earner can contribute a maximum of $5,500 a year, being under age 50. Those who are 59 and older can contribute up to $6,500 a year (2015 allowable contributions).
Let’s look at the power of this tax-free income vehicle, if embraced early on in one’s career:
A 30-year-old wage earner who contributes monthly to their Roth IRA, whose investments net 8.5% in example, will have accumulated approximately $278,427 by age 50! At age 50, they are now able to contribute $6,500 a year. Doing that for just ten years, at age 60, this individual now has approximately $729,525 tax-free! And it gets better. Historically, the limits to the amount you can contribute to a Roth IRA have steadily increased, so chances are they may increase in the future, allowing you to contribute, and thus accumulate, much more!
So, when asked, “Which would you choose: Tax-Free income at Retirement or Taxable income?” Hopefully this article has helped form your answer.
Now, for those whose income exceeds the allowable limits ($118,000 for those filing Single in 2015), a close alternative would be a non-retirement account. After tax dollars are contributed (not be taxed again), only the growth would be reportable as income. If accessed by monthly withdrawals from an investment account holding stocks, mutual funds, Index funds or ETFs, a considerable amount of that income is tax-free because it is Principle – the money you placed into the account which was already taxed. I write about this type of plan in Against the Grain, Avoiding the Financial Pitfalls of Conventional Wisdom, available here: http://amzn.com/B005X9IYKQ