How many vehicles do you own? Are they equal or do distinct qualities differentiate which vehicle may complete a task better than another? A landscaper certainly prefers the capability of hauling supplies in a truck compared to the trunk of a compact car. Conversely, a daily commuter favors the superior fuel economy of the compact car to the truck. Understanding your financial objectives and pairing the proper "vehicle" allows for effective means of completing the job.
Most common forms of retirement vehicles include: Roth IRA's, 401(k)'s, and Traditional IRA's. These are but a sample from the entire retirement vehicle "garage", and accessible to most of the general public. The plans mentioned all share one common characteristic that offers tremendous benefit to the individual; tax-deferred growth. The aforementioned plans utilize tax-deferral as the Internal Revenue Service deems them "qualified plans". For the long haul of retirement planning, utilizing tax-deferred growth via a qualified plan relieves the investor from taxes until withdrawals occur during retirement. For an example of tax-deferred versus taxable returns, click here.
While these retirement vehicles all offer tax-deferred growth, critically understanding how and when taxes are applied take precedence. Traditional IRA’s and 401(k)’s generally offer an upfront tax break.For example, a person earning $50,000/year contributes $5,000 to her 401(k) she will effectively lower her taxable income to $45,000. The tax benefit realizes immediately in this example. Now the IRS is smart, they won’t let you have your cake and eat it too. Once in retirement, or at least by age 70.5, a Traditional IRA account holder must begin withdrawing funds from the IRA which will be considered taxable income.
Alternatively to Traditional IRA’s, the ROTH IRA tax benefit functions in the opposite. A contribution to a ROTH receives NO initial tax break, the tax relief occurs during retirement. Under certain conditions (click here to learn more) Roth IRA distributions are tax free. For individuals planning on higher income during retirement can strongly benefit from the Roth IRA vehicle. No requirement exists for mandatory withdrawals from a Roth, yet another reason to consider when planning.
Determining your situation, whether tax savings now or tax saving later, determines which vehicle to pull from the garage. Alongside your financial advisor, a solid accountant can facilitate the decision of which option are viable.