Saturday, August 28, 2021

Retirement Savings: Traditional IRA vs. Roth IRA

As I begin to write this piece from a tea shop located in an old Victorian-style house in Portland, Oregon, I find myself feeling grateful for the opportunity I have each summer to experiment in designing the life I truly want to be living.  While I wear a number of professional hats, "teacher" is one that I am very proud to wear.  Each summer, I have two months off in which to rejuvenate and test the waters of life experiences that I may or may not want to fold into my daily life.  As I sip on my Lady Londonderry Tea Latte, I can't help but think this may be one of the most delicious tea lattes I've had in my entire life.  But then I realize that it may not only be the tea latte that I have a developed a taste for, but also the freedom that comes with the lifestyle I've made the subject of my current experiment.

Isn't freedom the very thing that is at the center of all of our hopes and dreams?  On some level, I think that we all long to wake up every day and do with it exactly as we choose, and for some, that may already be a reality. For the rest, this notion of freedom can feel abstract, a distant thought that we're afraid to believe in for fear that we don't entirely understand how to realize it.  

This blog isn't entirely about money.  It's also about choices.  I absolutely adore having choices.  I woke up this morning knowing I had a fair amount of work to do and feeling uncertain about getting it done "on time."  This is the sort of thing that has the ability to pull us down emotionally, feeling like we're racing against a clock with too much to do and too little time, but that wasn't my experience.  I was elated by the idea of getting to choose where to do my work today. "I'll get up, head downtown early, and go to the tea shop I found yesterday.  I can get a tea latte and get some work done.  When I need a break I might grab lunch or pop into the bookstore nearby..."  I felt aware of the work that needed to be finished, but not stressed out by it.  I felt excited to go out and experience my day.  When was the last time you felt that way?  What would it mean to you if you were able to afford yourself that kind of freedom without being on vacation?  How would it feel to wake up and realize that you were going to go to work 100% by choice, not because you had to?  How would it feel to wake up every day and choose what that day looks like?  Some folks may not dare to dream about days that look like that, other than the ones on vacation, but I believe we can achieve them.

In order to achieve the ultimate financial freedom, we need to secure our mindset first, which is a huge part of what influences this blog, my coaching practice, and my life in general.  Closely behind securing our mindset comes debt freedom and a secure traditional retirement.  Image it:  What would you do with your life if you had no debt and knew for certain that your retirement would already be secure?  You wouldn't need to worry about monthly debt repayments.  You wouldn't need to sock away hundreds of dollars every month for retirement anymore.  You would only need to finance your current needs.  If that was your current situation, would you do anything differently?  Even if you continue your day-to-day life in the same manner, wouldn't it feel different?

In my own life and journey toward the ultimate freedom, I am currently working to secure my traditional retirement, achieving Coast-FI.  The fundamental strategies of living below your means, investing the difference, and so forth are fairly simple.  But, a little knowledge goes a long way.  Selecting the retirement accounts to best suit our individual needs can really propel us forward in our process.  Hence, the current series I am working on, Retirement Savings, where I compare and contrast two different retirement savings vehicles in order to help individuals to educate themselves and select the tool that will work best for them.  So, today, we are taking a look at IRAs so that we can compare and contrast the traditional versus Roth option.

Origins:

IRA stands for "Individual Retirement Arrangement" and was created as a result of the Employee Retirement Income Security Act of 1974 (also known as ERISA).  Originally called "regular IRAs," they were first introduced and made available to the public in 1975, allowing people to contribute the lower of $1500 or 15% of their annual income into this retirement savings vehicle while also receiving a tax benefit in the process. This account type was considered revolutionary and one of the best deals out there.  Fast forward to 1997, the Tax Relief Act of 1997 is passed and the Roth IRA is born, being named after its chief sponsor, Senator Roth.  At this point the "regular IRA" is being called a "traditional IRA," and the Roth IRA gets introduced to the U.S. as the latest, greatest retirement investing vehicle on the scene!

Eligibility:

In order to contribute to an IRA, you must have qualified income.  This applies to both Roth and traditional IRAs.  In general, this means that your income comes from work.  Also, you can't contribute more to an IRA than you earned in qualified income (regardless of its annual limit).  If you earned less than its annual limit, that's all you can contribute.  There is no minimum age for contributing to either type of IRA as long as there is earned income to support the contribution.  There is also no maximum age limitation on contributions for a traditional or Roth IRA in 2020 and beyond.  This is a change. Before the SECURE Act passed, the age limit for contributing to a traditional IRA was 70 1/2, but has since been changed.  

There are income restrictions on Roth IRAs.  This is based on your MAGI and varies by filing status.  This is also something that should be checked annually for changes.  For example, in 2021, a single filer earning $140,000 or more isn't eligible to contribute to a Roth IRA.  A single filer, earning under $125,000 can contribute the full amount.  A single filer earning between those two amounts is in the phase-out, meaning they can contribute some but not up to the full amount.  These numbers are different for people that are married-filing-jointly, and for those married-filing-separately, the income limit is only $10,000.  Now, for those earning above the IRS limits for any particular year, there is a bit of a loophole.  You can still take advantage of a Roth IRA by making what is called a "backdoor" contribution.  If you plan on using this strategy, it would be a wise idea to seek professional help so that you do everything correctly.

Contribution Limits:

In 2021, you can contribute up to $6000 into an IRA.  This can be traditional, Roth, or a combination thereof.  If you are age 50+ you can increase that by $1000.

Tax Benefits:

Both traditional and Roth IRAs come with tax benefits, but how those benefits are received makes up the primary difference between the two account types.  A person using a traditional IRA may be able to receive a tax benefit in the year they make the contribution.  I use the word "may" because there are income limitations on the tax benefit associated with the traditional IRA for those that have access to workplace retirement savings plans.  But, a person that meets the income limit, can enjoy a tax break in the year of the contribution.  The way it works is simple. If they contribute $6000 and are eligible for a full deduction, it will appear on their taxes as if they made $6000 less, therefore, they pay taxes on a lower amount of income.

A Roth IRA works a bit differently.  People using a Roth IRA won't receive any upfront tax benefits.  They contribute "after-tax" meaning their pay has already been taxed before they contribute, and there isn't a tax break associated with the contribution that they collect in that year.  Instead, their money will grow tax-free.  This is a huge benefit because later, in retirement, when they take the funds out, no only will they have already paid taxes on the contributions, they also won't owe taxes on the earnings!  Tax-free growth is a big deal!  This is why people get so excited about Roth IRAs!

Required Minimum Distributions:

When you turn 59 1/2, you may begin taking distributions from a traditional IRA without incurring an early withdrawal penalty.  Of course, taxes will still be due.  This is because the contributions had been made pre-tax (Remember that tax break from earlier years?).  This same age restriction applies only to the earnings portion of a Roth IRA.  In order to truly have the Roth IRA earnings be tax-free, you have to wait until the minimum retirement age to take them out.  However, since taxes were already paid on contributions, you can take those out at any time.

Users of traditional IRAs are required to start taking distributions by age 72 if they haven't started doing so by then.  This used to be age 70 1/2, but was recently increased as a result of the SECURE Act for those born on or after July 1, 1949.  

Loans:

Technically, IRAs aren't set up for people to be able to take loans against.  So, that's not really a thing.  There are some things you can do.  For example, there is a rule with traditional IRAs that allow people to have the money out for 60 days without triggering penalties and such.  Honestly, I wouldn't be inclined to try that but if you want to investigate it, make sure you seek professional assistance so that you don't make any errors. There are also special Covid-related provisions that allow people access to their retirement accounts early.  With Roth IRAs, loans aren't really needed because you could take out your own contributions without any issue since they've already been taxed.  You just need to be really careful that you don't touch its earnings.  To be honest, I'm not in favor of raiding either of them early anyway.  But, I thought it important to note that they work a little differently so that you can do your homework if you think you might need access to the funds before retirement age.  

Conclusion:

One of the things I love about using an IRA comes full circle to the idea of choice.  Since IRAs aren't directed by your employer, you can open them at any discount brokerage firm you choose and invest your funds in any manner that you please.  This can really help you to maximize your returns!  I'd love to hear what kind of IRA you use, why you chose it, or any other tips you have about using either Roth or traditional IRAs in the comments below.

For Further Reading:

Retirement Savings: Roth IRA vs. Roth 401(k)

Retirement Savings: 401(k) vs. 457

My 3 Bucket Approach to Retirement Savings

A Roth vs. Traditional IRA (This one is from 2017, so some of the info is old but the chart in this piece is pretty useful still).


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    Thursday, August 19, 2021

    Retirement Savings: 401(k) vs. 457

    Within the last few years, a number of people in my life have retired.  While one of them likes to joke about the glamorous life she leads tending to her yard and scooping dog poop, the truth is that they're all living their best lives.  I am absolutely inspired as I watch them all make their individual choices to do things like snowbird, create a garden oasis, move to another state, build their dream homes.  They're all making different choices, but the fact remains that they have all positioned themselves to allow their money to support them in living their best lives.  I think we could all learn something from that wisdom.

    What do you want to do when you retire? Have you spent much time thinking about that?  I'm in the middle of a real estate transaction right now; buying a piece of real estate in which to live.  I can tell you that my partner and I were considering retirement goals and dreams when making this choice.  We wanted a serene atmosphere and the appropriate amount of space for our situation.  It was important that we could have it fully paid off by our desired retirement date, and that we could still save considerably for our retirement.  We are fairly adventurous and will likely want to travel, or at least have the option to travel.  Maybe we'll want to take a big RV trip or have a cottage by the lake.  The truth is that we aren't sure yet, but what we are sure of is the fact that we want choices, and that's something money can afford us.

    I talk so much about inspired action as a part of my process of using Law of Attraction in conjunction with my finances.  Imagining myself having all of these choices in front of me feels really inspiring and makes me really, truly want to save money. In part, I believe that I can have any of these things that I want, and beyond that belief lies a collection of actions I'm inspired to take.  Sometimes people get inspired to take an action, but then they get a little hung up on the technicalities of some financial tool or strategy because they don't fully understand them. This is where a little knowledge goes a long way! I get really excited about the idea of saving for my retirement, but I can see where people get a little confused.  I mean, I have SO MANY choices of retirement accounts that I can use?  My employer offers me a TDA, 401(k), and 457.  There are Roth options on both the 401(k) and 457, plus, I could use my IRA to save!  How are we supposed to decide which will serve us best?  In this mini-series, I am taking the time to compare some of the various retirement savings vehicles in order to help people with that very thing!  This week, I am comparing the 457 with the 401(k).  When I compare these two accounts, I am looking at the traditional versions of them.  It's important to realize that there might be Roth options available (there certainly are for me), and I do like to use them!  But, in comparing the traditional versions, we can gather a bit of data about some key differences in order to inform our choices.

    Overview:

    Let's start with a quick overview.  A 401(k) is a retirement savings vehicle that many employers offer as a benefit to their employees.  A 457 is very similar, except that a 457 is generally only offered to state and local government employees (and certain nonprofits).  So, oftentimes police officers, teachers, and other civil servants will have a 457 as an option.  Interestingly, the 401(k) is covered by the Employee Retirement Income Security Act of 1974, also knowns as ERISA, whereas a 457 is not.  This makes a 457 a nonqualified retirement plan.  Why does this matter?  If your employer has given you both options, you can literally contribute the max to both of them!

    Contribution Limits:

    I want to start by reminding you that contribution limits are subject to change and tend to be updated annually.  In 2021, a person using a 401(k) can contribute up to $19,500.  This limit is the same for the 457.  If you have access to a 457 and a 401(k), you should be getting ridiculously excited right now.  If you aren't, let me reiterate a point so you too can get excited.  If you have access to both a 401(k) and a 457, you could contribute a full $19,500 to the 401(k) and then turn around and contribute another $19,500 to your 457!  Again, this is because of what I said above about ERISA.  Now, if you're in the 50+ age category, this deal gets even better.  People in the 50+ category get what's called a "catch-up contribution," which basically means that you can contribute an extra $6500 per year to a 401(k) or a 457.  The catch-up contribution is the same for both!

    There's also a very strange little rule that applies to a 457 that could really work to your benefit if you know about it.  It's called the "Double Limit."  In the last three years of your working career, you are allowed to contribute double the annual contribution limit to your 457 if there were years in which you were eligible but not contributing.  To clarify further, you can take advantage of the double limit in the last three years prior to retirement or use the catch-up contribution, but not both.  This means for those three years, you could contribute up to $39,000 into your 457 if there were years that you hadn't been contributing (but were eligible).  That's a huge advantage!

    Employer Match:

    People like to talk about being sure to contribute enough to the 401(k) to get the full employer match. Quite frankly, I couldn't agree more!  Why on earth leave free money at the table!  Now, matches are really common with a 401(k), although they aren't required to do so.

    A company match is extremely rare with a 457. Oftentimes, people working for government entities receive a pension, therefore they don't typically get a match on top of that.  Now, in the rare event that you actually have a 457 with a match, there's an additional oddity you might want to be familiar with.  If a 457 has a match, the match counts toward the overall limit.  For example, if the annual limit is $19,500 and your employer puts in $10,000, you only have $9,500 left that you can contribute because both their contributions and yours in combination will have hit the limit.  It doesn't work that way with a 401(k).  With a 401(k), the match doesn't impact your contribution limit.

    Early Withdrawals:

    If you want to take money out of your 401(k) before you hit age 59 1/2, you will not only have to pay taxes on the funds, but you will also incur a 10% penalty!  Ouch!  No one wants that! Interestingly, that penalty doesn't exist with a 457!  Now, you'll still have to pay the taxes, but you won't have to pay a penalty for an early withdrawal.  If you're considering early retirement, that's a big deal!

    Conclusion:

    I hope reading this has given you a sliver of inspiration as you design your way forward, creating for yourself the financial life of your dreams.  Sometimes we get paralyzed by what we don't understand, and I get it, but just a little knowledge goes such a long way! As you wade through these comparisons, I hope some little nuggets of information jump out at you and inspire you to want to take advantage of something that is presenting you with the opportunity to live the life of your dreams. Don't you owe that to yourself?

    Further Reading:

    My 3 Bucket Approach to Retirement Savings

    Retirement Savings: Roth IRA vs. Roth 401(k)


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      Thursday, August 12, 2021

      Retirement Savings: Roth IRA vs. Roth 401(k)

      Over the years, my relationship with money has transformed so that I feel really good about my money.  I honestly feel great about my plan, where I'm going, my ability to spend on current lifestyle desires, and my future.  When I consider what really makes me feel good about my finances, it boils down to one thing: choices.

      I feel really great when I feel like I have a plethora of choices in front of me, plus I understand how to fold them into my lifestyle and financial plan.  Having choices that you understand can be incredibly empowering; though the opposite is true when the choices feel as though they need to be demystified, and you aren't sure which one to make.  Sometimes, a lack of understanding comes with an unfortunate case of paralysis.

      I recently gave a series of workshops introducing attendees to a variety of retirement savings options including IRAs, 401(k)s, and 457 accounts all of which have both traditional and Roth options.  While I spelled out various attributes of these accounts in a general sense, I feel that there is still much to say where some of the finer nuances of these accounts are concerned.  Again, since I'm the Law of Attraction Finance Gal, unofficially titled of course, I am all about feeling really good about our choices.  Subsequently, I feel the need to zoom in on some of finer details by comparing some of these account options because it is in these finer details that we find the inspirations that inform our next actions.  So, this week we will be comparing and contrasting the Roth IRA with the Roth 401k.

      History and Origins:

      Roth IRA was born as a result of the Taxpayer Relief Act of 1997 and named after Senator Roth, it's chief sponsor.  The idea behind this retirement savings vehicle was to give investors no immediate tax advantage, but a rather large payoff on the back end.  Because taxpayers investing in Roth IRAs would not receive a tax benefit upfront, they would be entitled to tax-free growth over the course of the life of the account. In other words, the taxpayer wouldn't have to pay any taxes on the funds (both their contributions and the growth) in retirement.  A few short years later, in 2001, the Roth 401(k) was also born having many some commonalities with a Roth IRA but others with the Traditional 401(k).

      Income Limits:

      When the Roth IRA was first conceived of, the IRS imposed an income limitation that did exclude some people from being able to take advantage of this account type.  This income limit changes every year and varies by tax filing status.  As of 2021, the income limit is $140,000 for single filers; $208,000 for those married filing jointly.  The restrictions for those that are married filing separately are significantly more strict, making it difficult for those filers to utilize a Roth IRA at all.  In recent years, a "workaround" to the income restriction has been introduced and it's called a "back door Roth IRA."  This allows people that earn more than the IRS restriction allows to contribute to a Roth IRA through a backdoor.  People basically contribute to a traditional IRA and roll it immediately to a Roth, paying the taxes in the current year. It's a roundabout way, but completely effective and legit. Anyone that is in this boat should do further research and might consider professional assistance to be sure they take the correct steps for this transaction. But, the key point here is that it can be done!

      A Roth 401(k) on the other hand doesn't have any income restrictions.  So, it can be a really great option for high-income earners.

      Annual Contributions:

      There are limits to what can be contributed to both Roth IRAs and Roth 401(k), although those limits are not the same.  

      In 2021 the IRS allows people to contribute $6,000 to a Roth IRA.  Investors aged 50+, are allowed what is called a "catch-up contribution." This allows them to contribute an additional $1000 annually.  This way, as Americans inch closer and closer to retirement, they can contribute more in order to "catch up" if they'd like. 

      The contribution limits for Roth 401(k)s align with that of traditional 401(k)s.  In 2021, plan participants can contribute up to $19,500 to a Roth 401(k).  There is also a catch-up contribution available for those ages 50+, but it's a fair amount higher.  The catch-up contribution for a Roth IRA in 2021 is an additional  $6500 annually.  

      Now, it's important to know these contribution limits are subject to change annually for both Roth IRAs and Roth 401(k)s.  They frequently go up something to the tune of $500 annually when increased.  So, you should double-check these numbers periodically.

      Loans:

      You can't really take a loan against a Roth IRA, but it's pretty much unnecessary. You can basically take your own contributions out any time you want. Just don't touch the earnings.  That's the part that will get you into trouble.  If you touch the earnings before you're allowed, you will incur a penalty. Nobody needs that.

      A Roth 401(k) will allow plan participants to take out a loan.  There is a restriction on the dollar amount thought.  You can technically take out 50% of the account balance or $50,000 whichever is smaller.    Big warning here!  If you fail to repay according to the loan terms, this becomes a taxable distribution!  Sounds messy, right?

      In general, I'm not at all an advocate of taking money out of retirement for reasons other than retirement.  But, I am presenting you with the information to do with as you please.

      Required Minimum Distribution (RMDs):

      A Required Minimum Distribution or RMD is basically the IRS forcing you to start taking the money out at a certain point in time.  In order to understand the concept, think about a traditional IRA or 401(k).  The government gave you the tax break and has gotten their cut yet!  So, at some point, Uncle Sam is standing there impatiently tapping his foot with his hand stuck out, demanding his share.  He only gets his share when you take your money back out.  So, he's going to require that you do so.

      There is no RMD with a Roth IRA.  So, if you don't use the money, you can leave it to your heirs.  If this is something you plan to do, I would highly recommend seeking professional guidance on the best strategy for doing this, but know that it's an option!

      Now, technically, there is an RMD with a Roth 401(k).  You are required to begin taking distribution by age 72 (it used to be 70 1/2, but that recently changed); however, there is a loophole (2 in fact)!  First off, if you are still working when you are 72 and not a 5% owner of the company for which you work, you might be able to avoid RMDs, and should contact the plan administrator for additional info.  The second loophole and this is a BIG one, involves rolling the Roth 401(k) over into a Roth IRA. Since the Roth IRA doesn't have an RMD, once you've done so, you're golden.  Also, you shouldn't have a tax bill for doing so because you already paid the taxes, right?  Easy peasy.  I would still say to have a professional help you with something like that just to make sure you cover all necessary bases.

      Investment Options:

      Many investment professionals will tell you to invest in a Roth IRA first because quite frankly, the world is your oyster where investment options are concerned. You simply use any discount brokerage firm to open the Roth IRA and then invest in literally anything you want!  This is not the case with a Roth 401(k).  Since Roth 401(k)s are employer-sponsored retirement plans, you will only be allowed to choose from the investment options they have selected from you. Oftentimes, they also have higher administrative fees.

      Early Distributions:

      In general, the age 59 1/2 is the magic number when it comes to taking retirement distributions.  This is the minimum age the IRS allows you to be "qualified" to take money out for your retirement without incurring a penalty (or taxes with traditional accounts).  That being said, there are some nuances that are slightly different with different account types.

      As previously stated, you can take your own contributions out of a Roth IRA whenever you like.  So, you don't particularly need to be 59 1/2.  However, that only applies to the money you put into the account. If you touch the growth prematurely, you'll be subject to a 10% penalty.  There are a few exceptions to this of course.  There are exceptions if you've held the account for 5 years or more.  They're things like a first-time home purchase, etc.  So, look those up if you think they apply to you.  To be clear, you'd probably want to spend a little time reading about "exceptions" as well as the "5-year rule."  

      If you take money out of a Roth 401(k) early, you can expect to incur a 10% penalty.

      Conclusion:

      I feel constantly inspired to find ways to save for my retirement, but I recognize that this inspiration can only come when a certain amount of knowledge, understanding, and a vision for my future are present.  So, I hope that this comparison of Roth IRAs to Roth 401(k)s has proven useful, and you too are feeling inspired to save money so that you can continue to create and live the life you are meant to live.  

      If there are any other tips or rules about Roth 401(k)s or Roth IRAs that you feel I've forgotten, feel free to mention them in the comments.  Subsequently, I am open to questions or suggestions for a future post.  Next week, I plan to zoom in on the comparison of a 401(k) to a 457 account.  Stay tuned!

      For Further Reading:

      My 3 Bucket Approach to Retirement Savings


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