Chances are that you are familiar with the process of choosing the right vehicle for you. For some, a large truck bed used for hauling heavy equipment is necessary. For others, it’s spacious seating for the family. I currently own a 2005 Blue Chevy Corvette. V8 engine, 400 horsepower, and 0-60 in 4.1 seconds. While that vehicle fits me currently, I can tell you that its two-seat capacity wouldn’t make any sense for my sister who has two young boys to chauffer daily. In retirement planning, we ask a similar question that warrants as much, if not more diligence – what is the best retirement savings vehicle? A savings vehicle is a type of account – it’s what you put your money in that carries it from point A to point B.
There are two major categories of retirement savings vehicles: Roth and Traditional. There are many different types of accounts that fall in each category, just like many producers make each type of vehicle. For example, in the Roth category, we have Roth IRAs, Roth 401(k)s, Roth 403(b)s, and Roth 457 plans. In the Traditional category, we have Traditional IRAs, 401(k)s, 403(b)s, Simple IRAs, and SEP IRAs to name a few.
Traditional IRAs are like the trucks of investing. You can make tax-deductible contributions to a traditional IRA, and load up both your contributions and the tax savings gained into the truck bed. The funds invested in a traditional IRA can then grow tax-deferred while in the vehicle. However, once you reach your destination, Uncle Sam comes asking for his share of the luggage – funds withdrawn from a traditional IRA are taxed at ordinary income rates.
The Roth IRA has opposite features compared to the traditional IRA. If a traditional IRA is a truck, then the Roth IRA is a sports car. Contributions can be made to a Roth IRA, and no deduction is
given to the IRA owner at the time of their contribution. You load up only the tax-paid passengers, no room for the IRS luggage to worry about. Funds can grow for many of years inside a Roth IRA, and all earnings and the original contribution can come out tax-free if certain rules are followed. It can be pretty appealing to not have any tax “drag” on the Roth IRA – it can grow fast. This is a great vehicle for young people who have a long time for the funds to grow without having to worry about paying tax on the earnings in the future.
The question of which vehicle is best boils down to a pretty simple answer: How does your tax bracket compare now to what it will be in the future? If you are in a lower tax bracket, a Roth IRA could be a better vehicle – it allows you to pay tax now at your lower tax rate, and avoid paying the tax in the future when your tax rate might be higher. However, for someone in a higher tax bracket year, a more appropriate vehicle might be a traditional IRA. This allows them to defer taxes now at high rates. While there are different models of retirement vehicles, the basic principles remain the same – pay tax at the lowest possible rates. The right vehicle will depend on an individual’s needs. It is best to talk with a CERTIFIED FINANCIAL PLANNER™ professional about your needs and they can help you choose the right
David Faskas, CFA, CFP®
Chief Investment Officer
KMH Wealth Management, LLC