What is an IRA and how do I pick between a Traditional vs. Roth? (Part 3)
Written By: Nick Nguyen | Read full profile
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Streamlined Decision Tree on figuring out whether you should open a Traditional vs. a Roth IRA
*There are 2 major jumps in the tax brackets, the first from 12% to 22% and the second from 24% to 32%.
**There are limits to how much you can deduct from your taxable income based on your earned income, which is why contributing your whole limit for that year may not be the most mathematically beneficial.
***There are such things as a Roth 401k now, so your money can still grow tax free, in which case, no need to rollover to an IRA unless you wanted to manage your account individually. Keep in mind, you can still contribute to BOTH an IRA and a 401k.
When I learned about IRAs, I quickly asked my parents if they had set them up too. Unfortunately, they hadn’t, so I was gung-ho to get them started because time is of the essence, and I wanted them to have excess in retirement.
Well, turns out there are some restrictions that will keep you from picking a Roth if you do choose it, and we haven’t considered another important retirement account - the 401k! So here’s a quick and colorful decision tree with some nuances on my thought process for picking which route to take.
The key to deciding whether or not you can even start a retirement account is to make sure you have at least $1 that you can spare (which if you read my post on Treat yo’ self first - financially, the Yuffie Way as a Millennial will be super easy) and have “earned income.”
Earned income as defined by the IRS is anything that includes:
- Wages, salaries, or tips (recognize this on your W-2)
- Commissions or any professional fees you may earn
- Any income you earned while being self-employed that you pay taxes on
- For veterans - nontaxable combat
If this applies to you, congratulations! We can now move to the red level about Modified Adjusted Gross Income (MAGI)!
Picking between a Roth vs. a Traditional can throw you into this dark hole of pros and cons. But what’s even worse is if you did all that research only to learn that you could only choose a Traditional IRA in the first place because you earn too much money! Every year, there is an income limit that prevents you from contributing to a Roth IRA, which kind of sucks if you want to manage your own portfolio through an IRA instead of leaving it with your employer’s 401k plan. BUT never fear, there’s a loophole. If you are making too much money and want to still capitalize on a Roth so your money can grow tax free instead of tax deferred as time flies by, let's revisit our good old friend taxes in the green level!
This step is the most important part of the entire process. The whole point of opening a retirement account, whether it be a Roth IRA, Traditional IRA, or 401k is because you want to shelter your money from being taxed. These are all legal and it helps folks who are already retired that may not be using many of the services that taxes pay for (like public school systems to name one). Now, the reason why I note 20% is because this is the first interval where the tax bracket makes a huge leap! In 2020, you get taxed 12% up until $40,125. Anything more than $40,125 gets taxed at 22% between $40,125 and $85,525! That’s a 10% jump! So for me, making $65,000 in 2019, I tried to use “good debt” and tax deductions to bring my income down as close as I could to the 12% limit. If you don’t have debt, another way to do it is by contributing to a Traditional IRA! Now this really depends on the individual and opportunity costs that may be lost, which we talked about in Part 2 of this series, so reflect on your earning potentials and consult a financial professional if you want some help crunching the different scenarios particular to you. Maybe you already contributed to a 401k, so your taxable income gets decreased by a maximum of $19,500 in 2020. Follow along to the magenta level to see what I mean.
Keep in mind, you can contribute to BOTH an IRA and a 401k! In fact, many prominent financial gurus have this whole checklist on how to distribute your money! One particular one that I personally like is JL Collins in his book The Simple Path to Wealth. You can also check him out at his blog. For most cases, if your employer matches your contributions, DO IT. It’s free money! In the light purple level, we talk about 401k vs. Traditional IRA in a bit more detail.
In general, throwing money into your 401k is the easiest way to reduce your taxable income and help get you closer to the previous tax bracket since your maximum contribution is $19,500 in 2020! If you can survive without that $19,500, DO IT. You won’t regret it when you’re getting ready to retire! Now, if your employer doesn’t match, then it might be better to open a Traditional IRA as well. This is typically because your employer’s 401k plan may incur a higher management fee/expense ratio.
Now if your employer has one of these cool new things known as a Roth 401k (yes, they do exist), WHAT ARE YOU WAITING FOR? Get on that like...yesterday! This is the holy grail of investments because you can put away up to $19,500 into a tax advantaged account! (Remember, contribution limits on IRAs are capped at $6,000 for the year 2020, and you can’t deduct contributions of a Roth 401k from your earnable income since it’s after-tax money). If you still have an extra $6,000 that you can put away in an IRA, the benefit of a Traditional IRA is that you can manage your money directly and put it into very low / no-fee index funds.
Don’t count yourself out either if you have a 401k and/or a Traditional IRA and think you can’t have your money grow tax free instead of tax deferred. There’s this loophole that seems complicated...but really isn’t and it’s called the Backdoor Roth Conversion!
A lot of people thought it was unfair that only people with lower scaled income could take advantage of tax free money. So the “high income professionals” got together and voted, so that this Backdoor Roth Conversion could take effect in 2010 (it came about from the 2006 Tax Increase Prevention and Reconciliation Act). This is your loophole into getting money into a Roth tax-shield!
At first, this is somewhat complicated because you have to understand what “pre-tax” and “after-tax” means, and there are ways to set up your 401k and Traditional IRAs so that there’s less paperwork involved. This is where chatting with your plan administrator and/or a financial advisor is really helpful in keeping things straight. BUT the general idea is to take after-tax money and convert it into a Roth IRA. If you had pre-tax money in these accounts, then you’d want to make sure you have some extra cash on the side to pay the taxes due for that amount of money, but if it can sit in a Roth shield for 5 or even 10 years, that’s a lot more saved from compounding interest!
People often shy away at this step because it gets complicated. I was reading about Backdoor Roths and a “Mega” Backdoor Roth Conversion and realized that it’s actually pretty straightforward - some people just try to make it more complicated than it needs to be. Keep track of whether or not your money is “pre” or “after” tax, transfer it to your brokerage account of interest, pay any taxes owed if it was pre-tax money and on any gains, and file some paperwork. The hard part is understanding the taxes, “pro-rata” rules, and how to file them. This is the one time where having a SOLID fee-based Financial Advisor and CPA will be 100% worth it to look over your numbers and help you figure out the best plan. Your brokerages can also help if you give them a call!
If you have a Roth, do it. You want all your gains as your account grows to be tax-free. Putting it in a Roth allows you to do that! But remember, the math doesn’t lie. If you’re only a few years from retirement or don’t have the money to pay any taxes due for a Backdoor Roth Conversion, then maybe gaining a few thousand dollars isn’t worth it. Again, it’s different for everyone, which is why you want to keep it simple. If you’re just starting out your careers and making some dough, this is an easy route to go. Once you start diving into multiple income streams, this may get a bit more complicated, so professional help and a solid foundation in managing money will really help you dampen that learning curve.
*Nguyening Lifestyles is not a registered financial service provider and does not give financial advice. All information in these posts are for entertainment purposes only. Nguyening Lifestyles is not liable for any actions or outcomes that transpired after your reading of the following post.
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