Earlier this week, I discussed the practicality of determining how many exemptions to claim as it impacts tax planning. While that topic holds a great impact on your current paycheck and any annual refund you may expect in the end you receive the same amount of money over a 1 year period regardless of what decisions are made. There are a great many factors that can impact your taxable income: dependents, mortgage interest, marital status, investment income, etc. to name few. Those are all critical pieces but most individuals allow those chips to fall as the may seeking to impact their tax liability through other means. In my opinion, the most critical variable of your overall personal finances, as it relates to tax planning as well as current and future cash flow, is retirement investments. The decisions made investing for retirement hold a major impact on your tax liability today as well as when you begin taking retirement distributions later in life.
What retirement account is best for you?
The primary question is when do you want to be taxed? The answer…whenever your tax bracket is lower. Most of us expect our income to increase marginally each year for cost of living increases, promotions, investment returns, etc. If that’s the case, it is reasonable to expect your tax percentage will also increase over time. If that’s the case, you’d be better off paying your taxes now. The medium used to invest after-tax dollars for retirement is a Roth IRA (or Roth 401K if your employer offers such).
Essentially you invest money into an IRA (or 401K) designated as a Roth; unlike traditional IRA’s or 401K’s those funds are not tax deductible increasing your current year tax liability. The wonderful result of paying more taxes now are tax-exempt distributions during retirement (or after the age of 59 ½). In addition to paying a lower tax rate now than you would later in life, consider that your investments will grow over time due to increase in value, reinvested dividends, splits, etc. So not only are you saving taxes on the contributions, but also allowing you to generate earnings on those investments over the years tax-free!
In this instance, your retirement contributions are tax deductible leading to a lower tax liability in the current year. However all distributions, principle contributed as well as any earnings on your investments are taxed when received.
Because the earnings over many years of investing will typically be significant, those opting for a Roth IRA will almost always, regardless of tax rate, benefit more as a result of those earnings being distributed tax free. I recommend anyone in low or middle tax bracket opt for a Roth IRA and gain the tax advantage in the future. Those in max tax brackets now should consider the following, invest retirement funds in a traditional IRA which generates a tax deduction in the current year. Use the tax savings from that deduction to invest in a Roth IRA allowing a portion of future distributions to be tax free.
Note that Roth contributions are capped at $5,500 per year (for all individuals under the age of 50. Those over 50 may contribute $6,500 under the “catch-up” rules.