Should I have an IRA or a Roth?
By: Erik Bloomfeldt
One of the most common question I run into on an almost daily basis is “Should I be saving in a pretax or after-tax account”? For a beginning investor this is a good question, but not the first question you should be asking. Here are the three most important considerations when beginning to invest (or if you have been saving for a while but really did not give it too much thought)
- How much should I save? (or should I be saving at all?)
- Where should I save it – IRA/401k or a Roth IRA/401k?
- What should I invest in?
Let’s tackle each item in order.
- How much should I be saving, if I should save at all? The single most important financial activity that you can implement into your life is to spend less than you make! Sounds elementary…and it is, but the vast majority of people in America spend more than they make, rack up consumer debt while chasing after the next shiny object. All the while completely ignoring their financial future.
Here is a rule of thumb. In order to have 80% of your current income in your retirement years, you will need to save 15% of your income from age 25 to age 65. Now I know some of you just swallowed hard and want to stop reading…but stick with me…
If Social Security will be available at its current level during your retirement, that will take care of about 5% of the average workers savings need. Additionally, if your employer offers a match of 3%, then you will only have to save about 7% of your income to hit the magic 15% number.
So it is not as scary as it sounds at first….aren’t you glad you kept reading?
- Where should I save? IRA or Roth? Having your savings diversified from a tax standpoint is extremely important once you begin withdrawing funds. Here is a simplified example: If you need to have $100,000 during your retirement years and you are in a 25% tax bracket and all your funds are in a tax deferred account, like an IRA or 401k, you would need to withdraw $133,333 and pay Uncle Sam $33,333 in taxes in order to net your $100k ($133,333 x 25% = $33,333) leaving you with $100,000.
Whereas if you had a Roth, or tax free account you would only need to withdraw $100,000 and pay no tax.
But what if you are in a 50% tax bracket, you would have to withdraw $200,000 to get your $100,000 net into your pocket?
So the bottom line here is that you won’t know your tax bracket until you need the money, Congress changes tax rates regularly, so it could save you literally hundreds of thousands of dollars to plan ahead and Tax-diversify your portfolio.
- What should I invest in? Many people are unaware that you don’t invest in an IRA. An IRA just lets you save in a tax diversified account, then you get to pick your investments from there. For example, most 401k’s and IRA’s will give you a set of mutual funds, stocks or ETF’s to invest in. Typically, an Advisor will tell you that you should have a little of everything so that if the market crashes you will not get hurt so bad in the downturn, but the other side of the coin is that you won’t profit as much when times are good. So what is an investor/saver to do?
What I recommend is a three prong approach:
- Core investments – these are your traditional diversified portfolios as described above
- Tactical Investments – this is where you or your advisor will select investments that are managed on a regular basis and changed based on market conditions, opportunities and threats. This is very difficult and much study needs to go into selecting a qualified money manager (they are out there, but difficult to find).
- Alternative investments – Like cash flow real estate. – Cash Flow is the name of the game in real estate. You will want to find an investment appropriate for yourself as not everyone is cut out to be a landlord. If property management is your thing, then go for it. If flipping houses is your thing then more power to you. But if like most people you don’t have the time, energy, expertise or interest in managing property, then finding a solid firm with a great track record of paying their interest payments and a solid portfolio, is the way to go.
Utilizing a “Self Directed IRA” may be the tool you will need in order to invest IRA or 401k funds in Alternatives. (See our post on Self Directed IRA’s)
This is proprietary information of Erik Bloomfeldt and can only be used with express written consent of the author.