There is one idea that almost every financial professional will agree on.
Compound growth is a beautiful thing.
That’s part of what makes a Roth IRA so valuable. You can start contributing money when you have earned income, and that money will grow and grow—tax free, so long as you follow the guidelines—indefinitely.
That’s a huge opportunity, and part of the reason I made a deal with my son.
Like most parents, I want to help my son prepare for a great future, but I also want him to learn the value of money and the discipline required to earn it. One of the qualifications to open a Roth IRA is that the owner of the account must have earned income. So, I told my son that for every $100 he saved in a Roth IRA, I would contribute $1,000.
He spent the summer working at the Atlanta Athletic Club, running food to and from the pool, and he knew what it took to earn $100. And for a teenager, that was a lot of money.
He researched compound interest so he could learn what he was really getting from the deal. And of course (he’s a smart kid, after all), he took me up on the offer. He saved diligently, and together, we contributed $3,300 to his Roth IRA.
Even if he never contributes to his Roth again (although I hope he will), he’ll see significant tax-free growth by the time he’s 60.
Of course, as with most financial opportunities, there are some guidelines for Roth IRAs. To withdraw on the earnings and not pay a penalty or taxes, the account must have been open for at least five years, and the account holder must be at least 59 ½, with a few exceptions.
To even contribute to a Roth, your modified adjusted gross income (MAGI) must be under $150k annually if you’re single; married couples must have a MAGI below $236k to contribute.
If you are under age 50, the annual contribution limit is $7,000, and if you are over 50, that limit is $8,000.
These restrictions are part of what makes it so important to start saving as soon as you can. Of course, for my son who is 18 and working a part-time job, these are non-issues. But for some people, these are frustrating hurdles to a valuable opportunity. I know couples who feel like by the time they have it in their budget to save, they no longer qualify to contribute to a Roth.
The good news is there’s another way for high earners to take advantage of this tax-free growth vehicle.
In 2006, the Economic Growth and Tax Reconciliation Act made it possible for investors to contribute to a Roth contribution through their 401(k). This option has become more widely available over the past several years, as more and more employers are offering it in their plans.
The great thing about this option is that even those exceeding the Roth IRA income limit can contribute money. You can still contribute after-tax dollars, and the balance still grows tax free.
These contributions count toward an employee’s total 401(k) contribution, so the standard limit still applies—$23,500 per year for individuals under 50, and 31,000 for individuals 50 and over. But you can split that $23,500 however you want—you can contribute $13,000 of pre-tax money to the 401(k) and $10,500 to the Roth. You can put all your contributions into the Roth one year, and all your contributions into pretax the next year. It’s up to you.
Both types of contributions are valuable, of course. Pre-tax savings in a 401(k) lightens your tax load today, and that can be hard to pass up. On the other side of the coin, money in a Roth grows tax free forever. When you withdraw that money in retirement, you don’t have to pay taxes on it—and that can be a huge advantage.
So how do you know which will benefit you more?
When it comes to taxes in retirement, there are two things to consider:
We have no idea what tax brackets will be in the future.
You don’t know (for certain) what you’ll be earning between now and your retirement.
You could be in a lower tax bracket when you retire, but you might be in a higher tax bracket. We don’t know what the tax codes will be, so there’s no way to know when you’ll be subject to your highest income tax. That said, if you and your spouse are at the height of your careers and having your best earning years ever, it may make sense to save more money in pretax than a Roth in the 401(k).
Wherever you find yourself, the most important thing is to diversify your tax load. That means saving money in all different types of accounts—those that allow pre-tax contributions, post-tax contributions; even investment accounts incur capital gains taxes, which will impact your financial picture differently.
Having money in different types of accounts gives you options in the future, which is important, given that so many factors about the future are unknown. You never know when you might need those tax-free earnings from the money you invested in your Roth years and years ago.
Of course, everyone’s situation and goals are unique, so it’s wise to review your financial plan with a professional who can give you personalized advice. If you’d like to discuss your retirement strategy or learn more about how you can save for your future, I’d love to help.