Retirement accounts are key to achieving financial independence. However, with all of the different types of accounts, it can be challenging to know which ones to use. Throw taxes into the mix and retirement planning gets even more complex! Throw early retirement into the mix and now you are royally screwed! The good news is that this post is going to discuss two types of accounts: Traditional IRA and Roth IRA. Specifically, how the new tax reform changed my IRA contribution strategy.
Brief Lesson On IRAs
Before I get into tax reform, let me give you a refresher on IRAs.
Traditional IRAs are a type of retirement account that are considered pre-tax. This means that every dollar you contribute is tax deferred until you decide to withdraw it. You cannot contribute as much money as you want tax deferred, however. The government imposes a $5,500 maximum if you are under 50 years of age. If you are 50 or older, you can contribute $6,500 per year.
Traditional IRAs also have strict rules around withdrawal of funds. You must be at least 59 and a half years old in order to withdraw funds penalty free. Any funds withdrawn are subject to ordinary income tax in the year of withdrawal.
As I said, this lesson on Traditional IRAs was going to be brief. For a better understanding of this, I suggest visiting Traditional IRA vs. Roth IRA – The Best Choice for Early Retirement by the Mad Fientist.
Roth IRAs are a type of retirement account that are considered post-tax. This means that you have already paid taxes on every dollar you have contributed in that contribution year. The government still imposes a $5,500 maximum contribution if you are under 50. Like the Traditional IRA, this maximum gets raised to $6,500 if you are 50 or older.
Roth IRAs are a bit more flexible since they are funded with post-tax dollars. You are allowed to withdraw all of your contributions, after the account has been open for 5 years, completely penalty free (though not gains). Lastly, since these are funded with post-tax dollars, all withdrawals made after 59 and a half are penalty and tax free (along with the gains).
At this point, you might be asking where these retirement accounts fit into early retirement. After all, what good is money that you can’t fully access until you are 59 and a half. Well, I am glad you asked! Let me briefly explain ways to access funds early. Then, I’ll finally get to my revelation!
I am not going to dive too deeply into the different ways to access retirement funds early. Again, I will point you to the Mad Fientist, specifically his post titled How to Access Retirement Funds Early.
Basically, there is this completely legal way to rollover funds from a 401k into a Traditional IRA. From there, you slowly roll those funds into a Roth IRA and pay taxes on them. The funds rolled over from a Traditional IRA to a Roth IRA are considered contributions. If you remember what I said earlier, the benefit of a Roth IRA is that you can withdraw all contributions after 5 years.
What does this mean for folks not seeking early retirement? As you can probably see above, early retirees prioritize 401k and Traditional IRA contributions in order to defer taxes. As a regular retiree that still cares about building wealth, you should prioritize whatever will save you the most money.
What do I mean by the most money? Typically, this is based on two factors: your current tax bracket and your expected tax bracket in retirement. I’ll explain a bit more in the next section.
Well, up until now, this post has been providing you the context that you need in order to truly appreciate the lesson that I learned. Let’s dive into what I learned, and how you can apply it to your retirement plan.
Tax Reform and My Plan
Up until this week, I was prioritizing 401k and Traditional IRA investing for two reasons:
- I wanted to take advantage of early access to my funds (early retirement)
- I thought it was the most tax efficient way
Well, I was completely wrong about both points. There is not much to say about point number 1. There is a lot to say about point number 2. I thought that I was being extremely tax efficient in my retirement planning. In a sense, I was until Trump’s tax reform. I have since decided that I will no longer contribute to a Traditional IRA. Instead, I plan on maximizing my Roth IRA.
Jon and Jane Doe In 2017
This section is going to include numbers. I warned you.
With the drastic change in tax brackets and standard deductions, I realized that I was better off paying the taxes now while I was in a lower tax bracket. Let me explain via an example.
For this example, we are going to use my favorite family, Joe and Jane Doe. For simplicity’s sake, we will assume that Joe and Jane make a combined $135,000 per year, have no kids, and are actively saving for retirement. In 2017, Joe and Jane contributed $18,000 into each of their company sponsored 401k accounts. So far, that leaves their taxable income at $99,000.
Jane and Joe did not want to only contribute to their 401k accounts. They understand that IRA and Roth IRAs are awesome vehicles to build wealth. They decided that after taking a standard deduction and personal exemptions, their taxable income would be $78,200. In 2017, that would put them in the 25% tax bracket.
The Doe’s figured that they would definitely be able to live on around $50,000 per year in retirement and figured they would be in a lower tax bracket in retirement. This led them to contribute $5,500 in each of their Traditional IRAs. Essentially, they deferred a 25% tax on $11,000 dollars per year until retirement, when they would pay less.
Jon and Jane Doe in 2018
This same Doe family understands that the tax reform means it is time to visit their retirement plan. Let’s make all of the same initial assumptions as we did for 2017.
Jon and Jane decide that they will continue to max out their 401k accounts. In 2018, the maximum contribution has increased to $18,500 each. With that, Jon and Jane’s taxable income is $98,000 (down from $99,000 in 2017). They both decide that they want to continue putting more money away into their IRA. However, they revisit whether or not they should switch to a Roth IRA.
With the standard deduction being increased to $24,000, Jon and Jane’s taxable income after deductions is $74,000. While this is not very far off from 2017’s figure, the key take away is their new tax bracket. This puts Jon and Jane in the 12% tax bracket. What a difference! Knowing this new information, Jon and Jane decide that they need to take advantage of being in such a low tax bracket by contributing to a Roth IRA instead.
What This Means For You
If you are already saving for retirement in these tax advantaged accounts, then good for you! You are already taking the correct steps towards financial independence and retirement.
I recommend going through the Jon and Jane Doe exercises every so often. Generally, there are no changes in tax code or in your finances, you can probably skip these exercises. In this instance, the tax code change required the Doe family to adjust their plan. It also required changes in my own plan!
To recap, the exercise looks a bit like this:
- Estimate your income for the year
- Subtract pre-tax contributions to your 401k, 403b, or HSA accounts
- Subtract any deductions (typically standard deduction)
- The number you get will determine your tax bracket
- Decide based on your tax bracket whether or not you should contribute to your Roth IRA or Traditional IRA
Of course, given the various other rules imposed on IRA contributions, you should always seek the guidance of a tax professional.
I hope you got something out of my Jane and Jon Doe story. I am sorry if I disappointed you and didn’t teach you more about IRAs.
It is my general feeling that Roth IRAs are going to bit more popular in this current tax climate. Given that taxes are historically low and there are stricter income limits on Traditional IRAs, I would guess that Roth IRAs are hot this season.
Leave a comment below telling me how this exercise went for you! Let us know if you were able to make adjustments to your retirement planning.