Saving for retirement is very important, especially in pursuit of FIRE. If your goal is to retire early, what is the best IRA for you?
In this blog, I’ll explain the 3 key differences and explain why I choose one over the other.
Traditional IRA
Taxes
- Money you contribute to a Traditional IRA is not taxed.
- All money (contribution and growth) you withdraw during retirement is taxed as income
- You receive an immediate tax benefit every year you contribute to a Traditional IRA (assuming you meet income limitations)
- If you expect to be in a lower tax-bracket when you retire, Traditional is probably right for you.
Contributions
- Contributions are pre-tax or can be after-tax
- 2020 Max Contribution is $6000
- 2020 Max Contribution if over age 50 is $7000
- Anyone can contribute
Withdrawals
- Withdrawals are taxed as income after age 59.5
- Penalty free if withdrawn after age 59.5
- There are mandatory distributions after age 72.
Roth IRA
Taxes
- Money you contribute to a Roth IRA is taxed as part of your income.
- All money (contribution and growth) you withdraw during retirement is not taxed.
- You receive no immediate tax benefit each year you contribute to a Roth IRA.
- If you expect to be in a higher tax-bracket when you retire, Roth is probably right for you.
Contributions
- All contributions are after-tax
- 2020 Max Contribution is $6000
- 2020 Max Contribution if over age 50 is $7000
- Anyone below a certain income limit can contribute (Single – $139k, married filing jointly- $206k)
Withdrawals
- Withdrawals are tax free after age 59.5 and after 5 years
- Penalty free if withdrawn after age 59.5
- There are no mandatory distributions
Which one is better?
Determining whether Roth or Traditional IRAs are better for you, is not a hard question to answer. The main point you have to ask yourself is, do you want to pay taxes now or do you want to pay taxes later?
I prefer to pay taxes now, the opportunity for tax free growth is too attractive for me to pass up. My goal in retirement is to pay as little taxes as possible, so Roth IRA is right for me. We contribute to Roth IRAs, Roth 401k, and Roth 403b.
For those of you that make above the income limit to contribute to a Roth IRA, you can do what is called a “Backdoor Roth IRA”. Essentially you contribute to a Traditional IRA, then immediately roll it over to a Roth IRA. You have to do this separately each year.
When you roll the IRA over, you will have to pay the taxes on the money because you are converting from a pre-tax to an after-tax account.
Another benefit of Roth for FIRE pursuers
Roth IRA, Roth 401k, Roth 403b, etc contributions only (not growth) can be withdrawn penalty free after 5 years.
When you retire early, your Roth account can become part of your income stream. If you max out a Roth IRA and Roth 401k each year as a married couple for 10 years, your contributions would total $500,000 ( [$6k+$6k+$19k+$19k]x10).
My goal is to not have to withdraw from Roth accounts before age 59.5, but it is nice to know this money can be available penalty free.
Conclusion
For those pursuing FIRE, I recommend Roth accounts if you want to pay taxes now and none in retirement.
However, if you want to do some planning I highly recommend Traditional accounts, because of the tax loophole you can use to avoid taxes and penalties in early retirement.
However, performing a Roth conversion ladder could leave you with no taxes now (on your contributions) and no taxes later when you withdraw the money. How this is possible is covered in my blog on Roth conversion ladders.
When you retire, would you rather pay an income tax or none at all?
Current USA tax brackets for 2020 range from 10% to 37% depending on income level, with Traditional investments- you will be paying just that, 10-37% of your withdrawal amount.
If all your income is pulled from Roth investments, your income taxes will be 0%.
What retirement accounts do you invest in?
Financial Free Runner 