If someone were to ask me for two keys to retiring in financial comfort, my first answer would be starting to save early and letting time work its magic. My second answer would be taking advantage of retirement accounts and the tax breaks that come with them.
Most full-time workers contribute to a 401(k) plan because it’s offered through their employer, and they’re automatically enrolled. Unfortunately, far fewer (37% of households) have an individual retirement account (IRA) and take advantage of the benefits they can provide.
There are two main types of IRAs: traditional and Roth. Ultimately, the difference between the two comes down to when you get your tax break, and that’s generally how people choose between the two. With a traditional IRA, you get your tax break upfront with a tax deduction, but you’ll owe taxes on withdrawals in retirement, which are required beginning at age 72. With a Roth IRA, you contribute after-tax money, with the ability to take tax-free withdrawals once you turn age 59 1/2.
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The most you can contribute to the two IRAs, both Roth and traditional combined, is $6,000 a year ($7,000 if you’re 50 or older). If you’re eligible to use a Roth IRA, you should absolutely consider it because it can make capital gains taxes irrelevant.
It pays to use a Roth IRA
To really see just how valuable it can be to have your investments compound tax-free, let’s imagine there are two people, one who invests in a brokerage account and one who invests in a Roth IRA. If both people invest $6,000 annually for 20 years, receiving 10% average annual returns, they’d have around $343,650. The person who used the Roth IRA would get the full $343,650 (if they’re eligible), but the person who used the brokerage account would owe taxes when they sold the shares.
Since they only personally invested $120,000 over the 20 years, $223,650 would be capital gains ($343,650 minus $120,000). Assuming they earn $40,400 or more annually, the minimum they’d pay in capital gains taxes is 15%, which would be over $33,500.
The money saved on taxes in retirement can easily reach tens of thousands of dollars. It’s not farfetched for someone who uses a Roth IRA their whole career to accumulate around $1 million by retirement. Of that, hundreds of thousands is likely to be capital gains. At a 15% capital gains tax rate, that’s $15,000 owed per $100,000 in capital gains.
Take advantage while you can
For younger investors who may be earlier in their careers, it makes more sense to go with a Roth IRA and pay taxes on the money now while you’re in a lower tax bracket instead of later in your career when your tax bracket will likely be higher. As you advance through your career, you may also find yourself ineligible for a Roth IRA due to its income limit.
To be eligible to contribute to a Roth IRA for tax year 2022, you have to earn less than $144,000 if you’re single, $214,000 if you’re married and filing jointly, and $10,000 if you’re married and filing separately. Once you cross that threshold, you can still utilize a Roth IRA, you’ll just have to go with the backdoor Roth IRA route. A backdoor Roth IRA is when you contribute to a traditional IRA — which has no income limit — and then convert it to a Roth IRA. There’s an income limit on Roth IRA contributions, but not conversions.
One piece of the puzzle
Due to the relatively low contribution limit, IRAs are better used as supplemental income in retirement than your primary income source. Still, with enough time and consistency over a career, they can play a huge role in your retirement finances. If you accumulated $300,000 worth of stocks in your Roth IRA that paid an average 2.5% dividend yield, that’d be $7,500 in tax-free annual dividend income. You can’t survive off that alone, but an extra $7,500 annually would do anybody good.
The IRS isn’t known to give breaks in many areas, but retirement is one of them. As you’re saving for retirement, you might as well get tax breaks along the way. There’s no doubt you’ll be glad you did.
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