I talked about some of the important contributions limits for 2016 here, and you may be wondering if you should open a Traditional and/or Roth IRA (as some people asked me after I shared that post).
Recall that you can contribute $5,500 in 2016 ($6,500 if you’re 50+) to these Individual Retirement Arrangements, but this is a combined total. So, if you have two Traditional IRAs and one Roth IRA, the sum of your total contributions to all three of these accounts cannot exceed $5,500.
There is rarely good reason (in my experience) to have multiple Traditional and multiple Roth IRAs. To help streamline your accounts and simplify your record keeping, I recommend one of each – IF they make sense at all.
With a Traditional IRA, you are typically contributing PRE-TAX dollars. This would most likely come up if you have an old 401(k) you’re wondering what to do with. Instead of leaving it with your prior employer’s 401(k) administrator, you can roll it into a Traditional IRA. This opens up your investment options, as you are no longer limited to the list of available investment options within your 401(k) plan. As many of us will have multiple jobs over our lifetimes, this also helps you keep track of your retirement savings – as opposed to having multiple 401(k) accounts with multiple employers. Gains (the growth you get from investing) are NOT taxed in Traditional IRAs until you take the money out. Again, this is a retirement vehicle so we’re talking age 59 1/2, at least.
With a Roth IRA, you are contributing POST-TAX dollars. This may be a valuable retirement savings vehicle if you want to save beyond your 401(k), through another vehicle, or do not have an employer sponsored retirement plan. In this case, you are investing some of your net income (meaning it’s already been taxed). The big benefit here is that this money grows tax free. You will not be taxed again on your initial contributions and at all on the gains (as long as you satisfy the requirements). At a high level, if you’ve had the account for at least 5 years and are at least age 59 1/2, you’re good to go – no more dollars are going to the tax man. This is a huge advantage, especially if you are “young.” This means your money grows over time and you NEVER pay taxes on it again. There’s the potential for a lot of growth that is then never taxed.
For example, say you contribute $5,500 at the beginning of 2016 (the maximum amount) at the age of 30, never contribute or touch the money again until age 60, and earn an average rate of return of 6% per year for the 30 year period. Where does that leave you? That’s $31,589 at age 60 that’s yours, absolutely tax free, including the $26,089 of growth. Now, let’s say you contribute the maximum $5,500 (assuming the limit stays the same) at the beginning of each year for seven years in a row and then let it grow. How much do you have at age 60? About $187,000 – again all tax free! This time, the money has grown $148,500 and you do not owe taxes on it.
Remember, you can only contribute to a Roth IRA if you make less than the thresholds. You can refresh your memory on those here.
Traditional IRA: no taxes now, but TAXES LATER
Roth IRA: TAXES NOW, but no taxes later
One additional note: It can make sense to convert a Traditional IRA to a Roth IRA. Essentially, you pay the taxes on your entire Traditional IRA balance to convert it to a Roth IRA. Depending on your tax bracket, this may be worth doing. If you’re in a low tax bracket, or will be for a particular year, that may be the time do it as you will owe less in taxes on the balance you are converting.
There are several platforms that allow you to open Traditional and Roth IRAs. Vanguard is one of them. If you are looking for a platform that will do the rebalancing work for you over time (the newer, so called “robo” advisors), you might try WealthFront. These are just two options among several.
These things are worth considering and thinking through completely and specifically to your situation. Let me know if you have questions.
To my east coast friends, I hope you’ve enjoyed the snow and were able to Let Luc on your snow days.
Until next time,