By Steven J. Weil, Ph.D., EA, President, RMS Accounting
When it comes to retirement and Uncle Sam, the choice is often, “pay me now or pay me later.” At some point, you will generally not only pay for the earnings you put away, but also for the income and growth they generate.
The exception: a ROTH retirement account. ROTH accounts come in many flavors, including ROTH IRA, ROTH 401(k) and ROTH 403(b) plans. Because of the many choices, it’s important to do your homework and also to have a little bit of fortune teller built into your DNA.
If you believe that you will retire in a higher tax bracket than you are in today and that the value of having a little more to invest by delaying the tax on today’s earnings, then one of the ROTH choices may be best for you. Putting money into a ROTH account means you won’t get a current tax deduction; but if you meet the holding requirements (at least 5 years) and the age requirement (59 ½), all distributions, including growth and income reinvested, will come to you and your beneficiaries tax free. In addition, no tax will be due on any income or gains while in the account, and you get tax-free growth and income by only giving up a current tax deduction for funds contributed.
To be eligible to make a ROTH IRA contribution you must be income qualified, meaning that your ability to contribute phases out as income reaches certain thresholds. But even those with too much income to qualify for a ROTH IRA can make a regular IRA contribution and then roll that contribution over to a ROTH IRA. Like regular IRAs, Roth IRA contributions are limited to no more than $5,500 of earned income per taxpayer and $6,500 for those aged 50 or older.
For the self-employed, controlling shareholder of a corporation or managing member of an LLC, there are many other retirement plans to choose from. Some require high wages to maximize benefits. Others require less in wages but also restrict how much can be deferred. There are many types of plans for the self-employed as well as those who own and operate corporations, e.g., SEP IRA, SIMPLE IRA, DEFINED-BENEFIT, DEFINED-CONTRIBUTION and 401(k). All must include employees and have contribution and funding rules that must be carefully followed.
Just as with a regular IRA, deferral means that while you don’t pay tax on income and growth while it is in the plan, you will pay tax when you take funds out of the plan. If your contributions are tax deductible or tax deferred, you will also reduce your current tax bill by deferring tax on your contributions, but you will have to pay tax on those funds when you take distributions.
In the example below, investing $5,500 annually in a tax-deferred account that grows at 8%, the tax-deferred balance after 20 years would be $271,826. The same investment in a taxable account at a tax rate of 28% with the tax being paid on 8% would have a balance of only $208,535 after 20 years.
The higher the return on your investments, the higher the tax rate will be; and the longer the term, the greater the benefit from tax deferral. But it’s important to keep in mind what the tax rate will be when you retire and how much in taxes you will be paying on your distributions.
Thus, this is a complex topic requiring important choices and some insight into the future. Will your income go up, placing you in a higher tax bracket? Will the government raise taxes, putting everyone on in a higher bracket? Will you retire making more or less than you are today? What kind of return do you expect to see on your investments?
All of these questions are important when choosing a plan that best serves your needs. One thing is certain: the longer you wait to start planning for retirement, the harder it will be to accumulate the funds you need. While how much you put away and what kind of plan you choose are both important, the most important thing is to start soon.
Dr. Weil, an Enrolled Agent, operates several businesses, including RMS Accounting (1984) and its division, Bookkeepers Now (1986). With his wife, Theresa, he oversees a staff of 16 full-time, year ‘round employees in their Fort Lauderdale offices. They consult clients on all tax matters, including tax preparation and planning, bookkeeping, payroll, estate planning, audit representation, and other financial services.
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