In truth, they’re very different plans, and they fill very different needs. If you can, you should plan to have both.

This is especially true if your 401(k) plan is fairly restrictive. A lot of them are. They charge high fees and offer very limited investment options. A traditional IRA is often the best strategy to work around those limits.

Let’s take a deep look at both plans, and particularly at where each stands out. I think you’ll agree having both makes a lot of sense. It’s one of the best strategies to supercharge your retirement savings, especially for early retirement.

How Traditional IRA Works

Basics

IRA Contribution Limits. You can contribute up to $7,000 per year or $8,000 if you’re age 50 or older. Contributions must be made out of earned income only.

That means wages, salary, commissions, self-employment income, or contract income. It does not include income from unearned sources, like pensions, Social Security, or investment income.

For example, if you earn $40,000, and only $4,000 is from earned sources, your IRA contribution will be limited to no more than $4,000.

Spousal IRA Provision. If you’re married filing jointly, and either you or your spouse has earned income and the other doesn’t, you may be eligible to make a spousal IRA contribution.

The only requirement is that the spouse with earned income must have sufficient earned income to cover contributions to both plans.

For example, let’s say you earn $50,000 per year, and your spouse is unemployed. You can make a $7,000contribution to your own IRA and a $7,000 contribution to a spousal IRA for your spouse. That will give you a combined contribution of $13,000, which will also be fully tax-deductible.

Required Minimum Distributions (RMDs)

Like every other retirement plan – other than the Roth IRA – traditional IRAs are subject to RMD rules. When you turn age 73, you’re required to begin receiving distributions from the plan.

The distributions are generally based on your remaining life expectancy. And because that expectancy reduces as each year passes, the percentage distributed from your plan will increase slightly.

In theory, the purpose is to exhaust the plan within your lifetime, providing the IRS with its expected tax revenue.

Tax Deductibility of Traditional IRA Contributions

For most taxpayers, the contributions made toward a traditional IRA will be fully tax-deductible. This is always true when neither you nor your spouse are covered by an employer-sponsored retirement plan.

What’s more, there’s no income limit on the tax deductibility of a traditional IRA contribution if neither of you is covered by an employer plan.

If either of you are, tax deductibility may be either limited or eliminated completely.

The tax deductibility of a traditional IRA contribution when you or your spouse are covered by an employer plan is based on your modified adjusted gross income (MAGI). That’s basically your adjusted gross income for tax purposes, with certain modifications.

If you’re covered by an employer-sponsored plan, you can still make a contribution to a traditional IRA. But the tax deductibility of that contribution will be determined by the following MAGI levels:

• Single or head-of-household contributions are fully deductible up to a MAGI of $146,000; the deduction phases out up to $75,000, beyond which it completely disappears.

• Married filing jointly, or qualifying widow(er), fully deductible up to a MAGI of $230,000 (up to $240,000); deduction phases out up to $124,000, beyond which it completely disappears.

• Married filing separately, contribution phases out up to a MAGI of $10,000, beyond which it completely disappears (no change from 2018 to 2019).

The numbers are different if you’re not covered by an employer-sponsored retirement plan but your spouse is. In that case, the tax deductibility of your IRA contribution is subject to the following MAGI limits:

• Married filing jointly, fully deductible up to a MAGI of $230,000; deduction phases out up to $240,000 in 2024, beyond which it completely disappears.

• Married filing separately, contribution phases out up to a MAGI of $10,000, beyond which he completely disappears.

Other IRA Tax Considerations

Investment Income Tax Deferral. Whether or not your contributions to a traditional IRA are tax-deductible, the investment earnings you accumulate in the plan are always tax-deferred. That means you can invest without worrying about tax consequences.

Tax-deferred investment income is worth having, even if your contributions aren’t deductible. Your investment nest egg will grow much faster with tax deferral than it ever will without.

Your investments will continue to grow on a tax-deferred basis until you begin making withdrawals.

Taxability of IRA withdrawals. You don’t begin paying taxes on your IRA until you begin taking withdrawals. You can take withdrawals beginning at age 59 ½, which will be subject to ordinary income tax.

If you made any contributions that were not tax-deductible, usually due to the income limitations described above, that portion of the distribution will not be taxable.

For example, if you have $100,000 in an IRA account, which consists of $60,000 in accumulated investment income, $30,000 in tax-deductible contributions, and $10,000 in nondeductible contributions, then 10% of any withdrawal will not be subject to income tax.

In that situation, if you made a withdrawal from the account of $10,000, $9,000 will be taxable. The remaining $1,000 will not ($10,000 X 10%).

This is what’s referred to as the IRS pro-rata rules. You won’t be able to declare that the first $10,000 withdrawn from the plan specifically represents your nondeductible contributions.

Early Withdrawal Treatment

If you withdraw funds from a traditional IRA before you turn 59 ½, you’ll be subject to ordinary income tax on the distribution, plus a 10% early withdrawal penalty.

For example, if you’re in the 12% federal income tax bracket and you make a $10,000 early withdrawal from your plan, you’ll have to pay $2,200 in tax. That’s 12% in ordinary tax plus the 10% early withdrawal penalty.

However, the IRS does have a list of exceptions to the penalty. However, you will still be required to pay ordinary income tax on the amount withdrawn.

Traditional IRA Investment Options

Self-Directed Investing. One of the biggest advantages of an IRA – traditional or Roth – is that you have complete control over the account. That means you can create your own portfolio, choose the investments that make it up, and buy and sell securities on your own timetable.

Account Trustee. You’re free to choose any trustee platform you want. You can choose any of the following trustees to hold the plan:

• A Bank, Particularly an Online Bank Paying High-Interest Rates

• Investment Brokerages, Like E*TRADE

• Managed Funds or Investment Accounts

• Mutual Fund or Exchange-Traded Funds (ETF) Families

• Robo-Advisors, Like Betterment, Wealthfront, or Ally Invest

• Peer-to-peer Lending Platforms, Like Lending Club or Prosper

• A Real Estate Investment Trust (REIT)

• Crowdfunding Platforms Like Peerstreet, Fundrise, and RealtyShares

If you’re looking for a Roth IRA account, check out these best Roth IRA options. 

Investment Options. There’s more good news here. You can hold just about any type of investment in a traditional IRA that you choose. The IRS has a very short list of prohibited investments, and they’re generally not the kind you would buy anyway.

As for what type of investments you can hold – just use your imagination! Mutual funds, ETFs, target date funds, individual stocks and bonds, certificates of deposit, options, gold, foreign currency, and real estate investment trusts.

A traditional IRA is the virtual antidote to a 401(k) plan with limited investment options.

How Traditional IRA Works

The Roth IRA Conversion

No discussion of a traditional IRA would be complete without mentioning the Roth IRA conversion. The conversion is available for both IRA and 401(k) plans. But it’s generally easier to do it with an IRA since it’s a completely self-directed plan.

While some employers do permit IRA conversions while you’re still employed, most will require that you remain in the 401(k) until your employment is terminated.

Why Do a Roth IRA Conversion? The Roth IRA has the lone distinction (along with the Roth 401(k), Roth 403(b), etc.) of providing tax-free income in retirement. It works much like a traditional IRA in that income within the plan is tax-deferred. It also has the same contribution limits.

But contributions to a Roth IRA are not tax-deductible. However, when you turn 59 ½, and if you have been in the plan for a minimum of five years, distributions can be taken tax-free. That includes distributions of both your contributions and your investment earnings.

One of the big advantages of a Roth IRA conversion is that there’s no limit on the amount of retirement money you can convert to a Roth.

You can build up the Roth account much more quickly by doing a conversion of, say, $100,000 from an IRA or 401(k), than by annual contributions of $6,000.

This is why Roth IRAs and Roth IRA conversions from other retirement plans, have become so popular.

The Tax Implications of a Roth Conversion

The downside of the conversion is that you will pay tax on the amount converted. The good news is there is no early withdrawal penalty, even if the conversion takes place before 59 ½.

Let’s say you’re in the 22% federal income tax bracket. You convert $100,000 from a traditional IRA to a Roth IRA. You’ll pay $22,000 – $100,000 X 22% – in the year you do the conversion.

But once you do, and you meet the Roth IRA age and plan length requirements, you can begin taking distributions tax-free.

This is the summary version of a Roth IRA conversion. I go much deeper into the topic of my Roth IRA conversion article.

How the 401(k) Works

Here are the basics of the 401(k):

401(k) Contributions

401(k) Contribution Limits. For 2024, the 401(k) contribution limit is $23,000, up $2000 from $20,500 in 2022. The catch-up contribution is now $7,500, also up $1000 from 2022. That means if you’re 50 or older, your contribution can be as high as $30,500 for the year.

Employer Matching Contribution. Many employers, particularly large ones, offer some sort of matching contribution. For example, if they offer a 50% match, and you make a 10% contribution, the total contribution will be 15%.

According to the Society for Human Resource Management (SHRM), 42% of companies match dollar-for-dollar on 401(k) contributions. If you make a 10% contribution, and your company will match 100%, your total contribution will be 20%.

Employer matching contributions are subject to vesting provisions. Vesting refers to the time it takes before the employer match is considered to be permanently yours.

Depending on the vesting schedule used, it can take anywhere from two years to six years before you become 100% vested in the employer match.

In theory, combined contributions to a 401(k) plan from you and your employer can be as high as $69,000 for 2024, up $5,000 from last year (or $76,500 if you’re 50 or older).

401(k) Funding Method. One of the big advantages of a 401(k) plan is the ease of funding it. Since it’s employer-sponsored, your contributions are made by automatic payroll deductions.

This is one of the simplest ways to fund any investment program, making it an easy path to wealth building. All you need to do is select your contribution percentage and let the contributions flow into your account.

If your employer offers a matching contribution, it will generally be made as your contributions are.

Tax Deductibility of 401(k) Contributions

Your contributions to a 401(k) plan are fully tax-deductible. What’s more, employer matching contributions are not taxable in the year received. Given the amount of contributions permitted under the plan, this can result in a substantial tax deduction.

Tax Deferral of Investment Earnings. Just as is the case with the IRA and virtually every other tax-sheltered retirement plan, investment earnings accumulate within the plan on a tax-deferred basis. That means you can invest without regard to income tax consequences.

This is a powerful compounding advantage since a 10% return on investment will actually be 10%. It won’t be reduced down to 7% if you’re in a 30% marginal tax bracket, as would be the case with a taxable investment.

Taxability of 401(k) Withdrawals. Neither your plan contributions nor the investment earnings on the plan are taxable during the accumulation phase. You’re eligible to begin making withdrawals from the plan after turning 59 ½.

Ordinary income tax must be paid on the distributions, which will include both contributions and investment earnings.

Early 401(k) Withdrawals. If you take distributions from a 401(k) plan before reaching age 59 ½, you will not only have to pay ordinary income tax but also a 10% early withdrawal penalty.

But as is the case with IRAs, the IRS has a fairly long list of exceptions to the early withdrawal penalty. However, you will still have to pay ordinary income tax on the amount withdrawn.

Other 401(k) Plan Features

401(k) Plan Investment Options. Generally speaking, your options will be limited to those selected by your employer. The employer will choose the account trustee and often the investments that will be available for the plan.

For example, the employer can have the plan administered by a mutual fund company, which would limit your investments to the funds offered by that company. In more liberal plans, the trustee may be a diversified investment broker.

If that’s the case, you may have investment options similar to those offered in a self-directed IRA.

Yet another disadvantage of an employer-sponsored plan is fees. There will generally be an annual fee charged by the plan administrator. You may also be locked in certain other fees, such as mutual fund load fees.

As a participant in the plan, your options will be limited to the fees charged and investments available within the trustee program.

401(k) Loan Privileges. This is a benefit available for 401(k) plans that can’t be done with an IRA. Loans are permitted under IRS guidelines, though not all employers offer them.

Under IRS regulations, you can borrow up to the lesser of:

1. The greater of $10,000 or 50% of your vested account balance, OR

2. $50,000

Now, it’s important to understand that the amount you can borrow from the plan is based on the vested balance, not the total balance.

For example, if your plan has $50,000, which includes $20,000 in investment earnings, $20,000 in contributions by you, and $10,000 in non-vested contributions by your employer, your base for calculating the loan amount will be $40,000.

Since you can borrow 50% of this amount, the maximum loan will be $20,000.

Required Minimum Distributions (RMDs) on a 401(k)

As you might expect, these are required on 401(k) plans, just as they are on traditional IRAs. You must begin taking distributions no later than age 73.

The distributions are based on your remaining life expectancy, which means the percentage distributed will increase slightly each year as you age.

Your 401(k) Plan May Offer a Roth 401(k)

An increasing number of 401(k) plans are now offering a Roth 401(k) option. This has become especially common among large employers.

What makes a Roth 401(k) provision especially attractive is that it offers much higher contribution limits than a Roth IRA. For example, the maximum you can contribute to a Roth 401(k) is the maximum that you can contribute to any 401(k).

Alternatively, you can split the contribution between the traditional and Roth portions of your 401(k).

This will probably be well advised. Just as is the case with a Roth IRA, contributions to a Roth 401(k) are not tax-deductible. If you contribute the full amount to the Roth portion of your 401(k), you won’t get any help on the tax side. That can cause a serious budget squeeze.

The withdrawal provisions for the Roth 401(k) are similar to a Roth IRA. You can begin taking penalty-free withdrawals from the plan once you reach age 59 ½ and have been in the plan for a minimum of five years.

If you participate in a Roth 401(k), the employer will carry separate balances for both the traditional and Roth portion of the plan.

What’s more, any employer-matching contributions on the Roth portion must be deposited into the traditional portion. This is to maintain the separation between pretax contributions (the employer match) and actual Roth contributions (your contributions).

Other Roth 401(k) Features

Roth IRA Conversion of the Roth 401(K). This is a real sweet spot because you can roll a Roth 401(k) over to a Roth IRA without tax consequences. This is because the Roth IRA and Roth 401(k) are equivalent plans from a tax standpoint.

Roth 401(k) RMD rules. Unlike a Roth IRA, a Roth 401(k) is subject to RMDs beginning at age 73. However, this won’t affect your tax situation since those distributions will be tax-free anyway. The only negative is that RMDs will deplete the account, reducing future account growth.

How the 401(k) Works

The Traditional IRA vs. The 401(k) Plan – The Advantages of Each

Comparing the two programs side-by-side, here’s a summary of the advantages each provides.

IRA:

• You choose the plan trustee.

• Self-Directed Investing – you can invest in anything you choose or even choose a third-party investment management option.

• You can set up a Spousal IRA for a nonworking spouse.

• Traditional IRAs are easier to do a Roth IRA conversion with since you have full control over the account.

401(k):

• Very high contribution limit.

• Employer matching contributions, making your total annual contribution even higher.

• Ease of contributions through automatic payroll deductions.

• 401(k) loan provision.

• Your 401(k) may come with a Roth 401(k) provision.

Why You Should Seriously Consider Having Both an IRA and a 401(k)

Remember at the beginning, I said this really isn’t about the traditional IRA vs. the 401(k) plan? Let’s spend some more time on that point.

If you can – and you usually can – you should have both plans going at the same time. Each provides its own unique set of benefits. But when you put the two together, you gain the advantages of both plans.

From the IRA, you get the benefit of completely self-directed investing, including using any investments you want. This isn’t typically available in 401(k) plans. You can also add your spouse to your IRA plan through a spousal IRA.

But from the 401(k) plan, you gain higher contributions (and a larger tax deduction!), as well as the benefit of an employer-matching contribution. There may even be a Roth 401(k) provision, which is always worth having. Then there’s the 401(k) loan option.

But perhaps the biggest reason to have both plans is the benefit of higher contributions.

If you’re able to make the full $23,000 401(k) contribution and you add a $7,500 IRA contribution, your total retirement contribution will be $23,000 (or $30,500 if you’re 50 or older).

With that kind of money flowing into your retirement plans each and every year, you’ll be a multimillionaire by the time you reach 65. Let that sink in. As contribution limits grow, so should your contributions.

As I said earlier, those increased amounts can make a major difference over the span of a few decades.

And maybe even more exciting is the prospect of early retirement. Start using dual retirement plans in your 20s or 30s, and you’ll be retired long before you turn 50.

There are two other situations where combining a traditional IRA and 401(k) is almost a requirement: 

• The traditional IRA contribution will be fully tax-deductible and/or

• When you have no employer-matching contribution.

The Bottom Line – Traditional IRA vs. 401(k) Plan – Which Plan Wins?

In weighing the pros and cons between a Traditional IRA and a 401(k) plan, it’s apparent that each serves unique financial and retirement planning needs.

While a 401(k) may offer a higher contribution limit and the perk of employer matching, its investment options can be restrictive and bound to the choices provided by the employer.

On the other hand, a Traditional IRA provides a platform for more diversified investment choices alongside some tax-deductibility features.

Moreover, the tax-deferred growth in both plans enhances the compounding effect, which is crucial for long-term growth.

Engaging in both plans could provide a balanced approach, allowing individuals to maximize employer contributions, enjoy tax advantages, and access a broader investment horizon.

The post Traditional IRA vs. 401(k) Plan – Which Plan Wins? appeared first on Good Financial Cents®.

Contributions to a Roth IRA are made with income that has already been taxed, meaning there’s no initial tax benefit, but the money you have in a Roth grows tax-free over time.

Roth IRAs don’t come with Required Minimum Distributions (RMDs) at age 73 like a traditional IRA either, so you can continue letting your money grow until you’re ready to access it.

When you do decide to take distributions from a Roth IRA, you won’t have to pay income taxes on that money. You already paid income taxes before you contributed, remember?

These are the main benefits of a Roth IRA that set this account apart from a traditional IRA, but there are plenty of others. With all of this in mind, it’s no wonder so many people try to convert their traditional IRA into a Roth IRA at some point during their lives.

But, is a Roth IRA conversion really a good idea? This kind of conversion can certainly be lucrative over time, but you should definitely weigh all the pros and cons before you decide.

When Would You Want to Convert to a Roth IRA?

Converting an existing traditional IRA or another retirement account to a Roth IRA can make sense in many different situations, but not all the time. At the end of the day, the value of this investing strategy depends on your unique situation, your income, your tax bracket, and the financial goal you’re trying to accomplish in the first place.

The most important detail to understand is that, when you convert another retirement account to a Roth IRA, you will have to pay income taxes on the converted amounts.

It can make sense to pay these taxes now to avoid more taxes later on, but that depends a lot on your tax situation now and what your tax situation may be like later in life.

The main scenarios where converting to a Roth IRA can make sense include:

• You will likely be in a higher tax bracket than you are now. If you are finding yourself in an especially low tax bracket this year or simply expect to be in a much higher tax bracket in retirement, then converting a traditional IRA to a Roth IRA can make sense. By paying taxes on the converted funds now — while you’re in a lower tax bracket — you can avoid having to pay income taxes at a higher tax rate once you reach retirement and begin taking distributions from your Roth IRA. (Not sure about your future tax brackets? Use the NewRetirement Planner to approximate your future taxable income, rates, expenses, and more. This comprehensive tool puts the power of planning in your own hands.)

Lifetime tax prior to performing Roth conversions

• You have financial losses that can offset tax liability from the conversion. Converting another retirement account into a Roth IRA will require you to pay income taxes on the converted amounts. With that in mind, it can make sense to work on a Roth IRA conversion in a year when you have specific losses that can be used to offset your new tax liability.

• You don’t want to begin taking distributions at age 73. If you don’t want to be forced to take RMDs from your account at age 73, converting to a Roth IRA can also make sense. This type of account doesn’t require RMDs at any age. (You can use the NewRetirement Planner to help you assess your income needs. See your taxable income for every future year and assess whether you need the income to cover expenses.)

• You’re moving to a state with higher income taxes. Imagine for a moment you’re gearing up to move from Tennessee — a state with no income taxes — to California — a state with income taxes as high as 12.3% In that case, it could make sense to convert other retirement accounts to a Roth IRA before you make the move and begin taking distributions.

• You want to leave a tax-free inheritance to your heirs. If you have extra retirement funds and worry about your heirs facing tax liability on an inheritance, converting to a Roth IRA can make sense. According to Vanguard, “The people who inherit your Roth IRA will have to take annual RMDs, but they won’t have to pay any federal income tax on their withdrawals as long as the account’s been open for at least 5 years.”

These are just some of the instances where it can make sense to convert another retirement account into a Roth IRA, but there may be others. Also note that, before you do anything drastic or begin a conversion, it can be smart to speak with a tax advisor or financial planner with tax expertise.

At the very least, be sure to model the conversion as part of a comprehensive written retirement plan. The NewRetirement Planner enables you to try out specific conversion strategies in the context of your entire financial situation. Assess the conversion on your tax liability, net worth at longevity, and cash flow.

When Would You Not Want to Convert to a Roth IRA?

Considering a Roth IRA conversion comes with immediate tax consequences, there are plenty of scenarios where doing one doesn’t make any sense.

There are also plenty of personal situations where a Roth IRA conversion would likely go against a person’s long-term goals. Here are some of the scenarios where a Roth IRA conversion could be a costly waste of time:

• You’re going to have an extremely low income in retirement. If you have reason to believe you’ll be in a much lower income tax bracket in retirement, then a Roth IRA conversion may not leave you better off. By not converting another retirement account to a Roth IRA, you can avoid paying taxes now at a higher rate for the conversion, and instead pay income taxes on your distributions at a lower rate in retirement.

• You don’t have extra money for the conversion. Because converting another retirement account to a Roth IRA requires you to pay income taxes on those converted funds now, this move is a poor choice in years when you are short on extra money lying around to pay more taxes.

• You may need the money sooner rather than later. Withdrawals on money that was part of a Roth IRA conversion are subject to a five-year holding period. This means you would have to pay a penalty on that money if you chose to take distributions within a five-year period after the conversion.

Again, these are just some of the scenarios where you would want to think long and hard before converting another retirement account to a Roth IRA. There are plenty of other situations where this move wouldn’t make any sense, and you should speak with a tax professional before you move forward either way.

Or, make sure you fully understand your projected income, expenses, and savings situation before doing a conversion. The NewRetirement Planner gives you a detailed insight into all aspects of your financial future.

Roth IRA Conversion Rules You Need to Know

Though there are income limits that apply to contributing to a Roth IRA, these income limits do not apply to Roth IRA conversions. With that in mind, here are some important Roth IRA conversion rules you need to learn and understand:

Which Accounts Can You Convert?

While the most common Roth IRA conversion is one from a traditional IRA, you can convert other accounts to a Roth IRA. Any funds in a QRP that are eligible to be rolled over can be converted to a Roth IRA.

60-Day Rollover Rule

You can take direct delivery of the funds from your traditional IRA (check made payable to you personally), and then roll them over into a Roth IRA account, but you must do so within 60 days of the distribution. If you don’t, the amount of the distribution (less non-deductible contributions) will be taxable in the year received, the conversion will not take place, and the IRS 10% early distribution tax penalty will apply.

Trustee-to-Trustee Transfer Rule

This is not only the easiest way to work the transfer but it also virtually eliminates the possibility that the funds from your traditional IRA account will become taxable. You simply tell your traditional IRA trustee to direct the money to the trustee of your Roth IRA account, and the whole transaction should proceed smoothly.

Same Trustee Transfer

This is even easier than a trustee-to-trustee transfer because the money stays within the same institution. You simply set up a Roth IRA account with the trustee who is holding your traditional IRA, and direct them to move the money from the traditional IRA into your Roth IRA account.

Additional Details to Be Aware Of

Note that, if you don’t follow the rules outlined above and your money doesn’t get deposited into a Roth IRA account within 60 days, you could be subject to a 10% penalty on early distributions as well as income taxes on the converted amounts if you’re under the age of 59 ½.

And, as we already mentioned, you’ll have to pay income taxes on converted amounts regardless of which rule you choose to follow above. You’ll report the conversion to the IRA on Form 8606 when you file your income taxes for the year of the conversion.

What Is the Backdoor Roth IRA and How Does It Work?

If your income is too high to contribute to a Roth IRA outright, the Backdoor Roth IRA offers a potential workaround. This strategy has consumers invest in a traditional IRA first since these accounts don’t come with income limitations in terms of who can contribute. From there, a Roth IRA conversion takes place, letting those high-income investors take advantage of tax-free growth and future distributions without having to pay income taxes later on.

A Backdoor Roth IRA can make sense in the same scenarios any Roth IRA conversion makes sense. This type of investment strategy intends to help you save money on taxes later at the cost of higher taxes now, in the year you make the conversion.

The big disadvantage of a Backdoor Roth IRA is a whopping tax bill, you’re hoping to lower your tax liability in the future. That’s a noble goal but, once again, the Backdoor Roth IRA only makes sense in situations where tax savings can truly be realized.

Modeling IRAs in Your Own Plan

Interested in a Roth IRA, but aren’t sure if it is right for you? Try modeling it in your own plan.

The NewRetirement Planner is the most powerful and comprehensive modeling tool available online. It’s for people who want clarity about their choices today and their financial security tomorrow. It gives people the ability to discover, design, and manage personalized paths to a secure future. Helping you make smart decisions about your money, including whether or not you should do a Roth conversion, is the heart of the tool.

You have two options for how to model conversions in the NewRetirement Planner:

Model Individual Conversions

Once you have set up all aspects of your plan (a really thorough inventory of your current and future income, expenses, and savings), you can try modeling a specific conversion that you think would be advantageous.

• In Money Flows, you can specify the account from which the money will be withdrawn, the amount you wish to convert, the age when you want to do the conversion, and your projected rate of return on the converted money.

• Once saved, you can immediately see if the conversion resulted in a change to your out-of-savings age, estate value, or lifetime tax liability.

• And, you can review charts to assess your tax liability in the year you do the conversion, the impact on income from RMDs, and more.

Lifetime tax after performing Roth conversions

Use the Roth Conversion Explorer

The Roth Conversion Explorer is a modeling tool within the NewRetirement Planner.

If you are not sure when or if you should do a Roth conversion, you might start with this tool. It will analyze all aspects of your plan, running hundreds of scenarios, to generate a conversion strategy that could increase your estate value at your longevity.

The Deadline to Convert a Roth IRA

The deadline for converting funds from a traditional IRA to a Roth IRA is the tax-filing deadline for the year in which the conversion is made. This is typically April 15th of the following year. This means that if you make a conversion in 2022, the deadline for reporting the conversion on your tax return would be April 15, 2023.

As I mentioned earlier, it’s also important to note that there is a deadline for recharacterizing a Roth conversion, which is October 15th of the year following the conversion. This means that if you converted a traditional IRA to a Roth IRA in 2022, you would have until October 15th, 2023 to undo the conversion by recharacterizing it back to a traditional IRA.

Steps to Convert an IRA to a Roth IRA

If you think a Roth IRA conversion would be a good move on your part, here are the steps you’ll want to take.

1. Open a Roth IRA

First, make sure you open a Roth IRA with one of the top brokerage firms. We think TD Ameritrade is one of the best Roth IRA providers out there due to the fact you pay $0 per trade and $0 per year. However, you should also check out top Roth IRA providers like Betterment, Ally, M1 Finance, and Vanguard.

• $0 per trade
• $49.99 mutual fund
• Annual: $0
• Minimum: $0

OPEN ACCOUNT

2. Transfer Existing IRA Assets to the Roth IRA

Next, you’ll want to initiate a Roth IRA conversion with your traditional IRA or QPR provider. Remember that, if you choose to accept the funds with a check, you have 60 days to move the money into your Roth IRA account. You can also have the funds moved via a trustee-to-trustee transfer or even using the same brokerage account, and this is often easier since the move should theoretically be taken care of on your behalf.

3. Pay Income Taxes On the Conversion

The major downside of a Roth conversion is that you will be paying taxes on the amount converted in the current year, and depending on your income tax bracket and the amount you’re converting, the tax bite could be substantial. With that being said, you will hopefully plan your conversion in a year when you’re in a lower tax bracket, or when you have other losses you can use to offset additional taxes caused by the conversion.

Converting IRA or 401k to Roth IRA After Age 60

Converting an IRA to a Roth after age 60 is possible, but it must be done properly in order to avoid tax penalties. The first step is to consult with a tax professional or financial advisor who can help you determine if this conversion makes sense for your specific situation.

Once the decision has been made to proceed, you will need to complete paperwork with your IRA custodian that requests the transfer of funds from your traditional IRA account into your Roth IRA account.

Depending on your age and other factors, you may also need to pay taxes on some or all of the money transferred from the traditional IRA. When the conversion is complete, you’ll have access to tax-free withdrawals from your Roth account once you reach the age of 59 1/2 and have held the account for at least five years.

Roth IRA Conversion Examples

Whenever you’re dealing with numbers, it’s always helpful to demonstrate the concept with examples. Here are two real-life examples that I hope will illustrate how the Roth IRA conversion works in the real world.

Example 1
Parker has a SEP IRA, a Traditional IRA, and a Roth IRA totaling $310,000. Let’s break down the pre-and post-tax contributions of each:

• SEP IRA: Consists entirely of pre-tax contributions. The total value is $80,000 with pre-tax contributions of $12,000.

• Traditional IRA: Consists entirely of after-tax contributions. The total value is $200,000 with after-tax contributions of $40,000.

• Roth IRA: Obviously all after-tax contributions. The total value is $30,000 with total contributions of $7,000.

Parker is wanting to only convert half of the amount in his SEP and Traditional IRA to the Roth IRA. What amount will be added to his taxable income in 2023?

Here’s where the IRS pro-rata rule applies. Based on the numbers above, we have $40,000 in total after-tax contributions to non-Roth IRA. The total non-Roth IRA balance is $280,000. The total amount that is desired to be converted is $140,000.

The amount of the conversion that won’t be subject to income tax is 14.29%; the rest will be. Here’s how that is calculated:

Step 1: Calculate the non-taxable portion of total Non-Roth IRA’s: Total after-tax contributions / Total Non-Roth IRA Balance = Non-Taxable %:

$40,000 / $280,000 = 14.29%

Step 2: Calculate the non-taxable amount by converting the result to Step 1 into dollars:
14.29% x $140,000 = $20,000

Step 3: Calculate the amount that will be added to your taxable income:
$140,000 – $20,000 = $120,000

In this scenario, Parker will owe an ordinary income tax of $120,000. If he is in the 22% income tax bracket, he will owe $26,400 in income taxes or $120,000 x .22.

Example 2
Bentley is over the age of 50 and in the process of changing jobs. Because his employer had been bought out a few times, he has rolled over his previous 401k into two different IRAs.

One IRA totals $115,000 and the other consists of $225,000. Since he’s never had a Roth IRA, he’s considering contributing to a nondeductible IRA for a total of $7,000 and then immediately converting in 2023.

• Rollover IRAs: Consists entirely of pre-tax contributions. Total value is $340,000 with pre-tax contributions of $150,000.

• Old 401k: Also consists entirely of pre-tax contributions. Total value is $140,000 with $80,000 pre-tax contributions.

• Current 401k: Plans out maxing it out for the rest of his working years.

• Non-deductible IRA: Consists entirely of after-tax contributions. The total value will be $7,000 of after-tax contributions and we will assume no growth.

Based on the above information, what will be Bentley’s tax consequence in 2023?

Did you notice the curveball I threw in there? Sorry – I didn’t mean to trick anybody – I just wanted to see if you caught it. When it comes to converting, old 401(k)s and current 401(k)s do not factor into the equation. Remember this if you are planning on converting large IRA balances and have an old 401(k). By leaving it in the 401(k), it will minimize your tax burden.

Using the steps from above, let’s see what Bentley’s taxable consequence will be in 2023:

• Step 1: $7,000/ $346,000 = 2.02%

• Step 2: 2.02 X $7,000 = $141

• Step 3: $7,000 – $141 = $6,859

For 2023, Bentley will have a taxable income of $6,859 of his $7,000 Traditional IRA contribution/Roth IRA conversion, and that’s assuming no investment earnings. As you can see, you have to be careful when initiating the conversion.

If Bentley had gone through with this conversion and didn’t realize the tax liability, he would need to check out the rules on recharacterizing his Roth IRA to get out of those taxes.

Examples are useful, but what is right for you?

Using these examples, it is time to try modeling Roth conversion as part of your own financial future. The NewRetirement Planner enables you to run different scenarios and see the impact on your finances.

Summary of Converting a Roth IRA

If you meet certain criteria and don’t mind facing a larger-than-average tax bill during the conversion year, a Roth IRA conversion could absolutely make sense.

However, you should absolutely weigh the pros and cons of this move before you pull the trigger, and you should definitely set aside the time to speak with a professional who can help you walk through the tax implications.

A Roth IRA conversion can help you avoid taxes later in life when you would really benefit from some tax-free income but don’t jump in blindly. Research everything you can about Roth IRA conversions and alternative ways to save more for retirement, and make sure any decision you make is an informed one.

FAQs on Roth IRA Conversions

The post The Ultimate Roth IRA Conversion Guide – Everything You Need to Know appeared first on Good Financial Cents®.

Not exactly.

While they do share some similarities, there are enough distinct differences between the two that they can just as easily qualify as completely separate and distinct retirement plans.

To clear up the confusion between the two, let’s look at where Roth IRAs and traditional IRAs are similar, and where they’re different.

Roth IRA vs. Traditional IRA – Where They Are Similar

Roth IRA vs traditional IRA – they’re similar only in the most basic ways. This is what often leads to confusion between the two plans and even a lack of awareness of the very specific benefits of each.

Plan Eligibility

Virtually anyone can contribute to an IRA, Roth, or traditional. The most basic requirement is that you have earned income.

Earned income is from salary and wages, contract work, or self-employment.

Unearned income – such as interest and dividends, pensions and Social Security, capital gains, and rental income – are not eligible income sources.

Even your kids can make contributions to either a Roth or traditional IRA. Though they can’t legally own an account, an IRA can be set up as a custodial account.

The account is in the name of the minor but is technically owned and managed by a parent or guardian. Upon reaching the age of majority – 18 or 21, depending on your state – ownership of the account transfers to the minor.

Either plan is an excellent choice, particularly if you’re not covered by an employer-sponsored retirement plan. It’s also the most basic type of retirement plan, which makes it very easy to open and manage.

In the normal course, you don’t even need to file any additional tax or reporting documents with the IRS.

One minor difference between traditional and Roth IRAs used to be that you couldn’t make contributions to traditional IRAs after age 73, though you could still contribute to a Roth IRA. But that distinction was eliminated for tax years beginning in 2020 and beyond.

You can now contribute to either a traditional or Roth IRA at any age, as long as you have earned income.

With both IRAs, the IRS has announced some 2023 changes that could benefit you.

Roth and Traditional IRA Contribution Limits

The two plans have identical contribution limits.

For 2023, IRS regulations allow you to make an annual contribution of $7,000. If you’re age 50 or older, there is a “catch-up contribution” of $1,000 per year, in which case your total contribution will be $8,000 per year.

There’s a secondary contribution limit that doesn’t apply to most taxpayers. However, it could affect high-income taxpayers who are covered by an employer plan.

The maximum contribution to all retirement plans in 2024 is $69,000 ($76,500 including catch-up contributions).

That includes contributions to an employer-sponsored 401(k), 403(b), 457 plan, or the federal government TSP plan. It also includes contributions made to self-employment plans, such as a Solo 401(k), or a SEP or SIMPLE IRA.

The combination of your contributions – including employer matching contributions – to any of these plans, including an IRA, can’t exceed these thresholds.

Tax-Deferral of Investment Earnings

Both a Roth IRA and a traditional IRA enable your funds to accumulate investment income on a tax-deferred basis.

This is a powerful investment advantage since it enables you to invest without regard for tax consequences. It means you get the full benefit of investment earnings and the extra compounding they provide.

Even if your contributions are not tax-deductible, the investment income earned will still be tax-deferred. This is the kind of advantage that can result in a 10% return on investment in an IRA account, compared to say, 7.5% in a taxable account (assuming a 25% tax rate).

Now if you’re already familiar with how a Roth IRA works, you’re probably thinking he’s wrong, Roth IRA investment income isn’t tax-deferred, it’s tax-free – he’s wrong! That’s partially true, and we’ll get to that in a little bit

You must be at least 59 ½ years old and have been in the plan for at least five years to be able to withdraw investment earnings tax-free.

If you withdraw money sooner, investment income will be fully taxable. So yeah, Roth IRA investment income is also tax-deferred, at least during the accumulation phase.

Investment Options

This is one of the biggest advantages of IRA plans, both Roth and traditional. As the owner of an IRA account, you’re free to invest any way you like.

You can choose the trustee, which can include any of the following:

• Banks

• Investment brokers

• Mutual fund companies

• Professionally managed accounts

• Robo-advisors

In fact, just about anywhere that you can invest money, you can set up an IRA account.

For example, peer-to-peer lending platforms, like Prosper allow IRA accounts. You can invest in personal loans through an IRA by doing this. You can also invest in online real estate crowdfunding platforms in your IRA using companies like Fundrise.

Within many of these accounts, you also have nearly unlimited investment options. This includes stocks and bonds, mutual funds and exchange-traded funds (ETFs), futures and options, commodities, government securities, and real estate investment trusts (REITs).

The IRS has a very short list of prohibited IRA investments. Those include:

Virtually everything else is fair game! And it makes no difference if it’s a Roth or traditional IRA.

Early Withdrawal Rules

This is where the comparison between the Roth IRA vs traditional IRA gets a bit technical.

Both plans provide for eligible withdrawals beginning at age 59 ½. If you take withdrawals sooner, they’ll be subject to ordinary income tax in the year of withdrawal, plus a 10% early withdrawal penalty tax.

There are exceptions to the early withdrawal penalty, but not ordinary income tax.

Even if an early withdrawal qualifies for an exception, you will still have to pay ordinary income tax on the amount of the withdrawal. Only the penalty is waived.

The IRS has a list of exceptions to the early withdrawal penalty. Two of the more common exceptions are qualified education expenses and up to $10,000 toward a first-time home purchase.

Roth IRA vs. Traditional IRA – Where They Are Different

So far, we’ve covered how the Roth IRA and traditional IRA are similar. Now let’s move on to where they’re different. And in many cases – very different!

Tax Deductibility of Contributions

We don’t need to spend a lot of time on this one. The difference here is simple:

• Contributions to a traditional IRA are usually deductible.

• Contributions to a Roth IRA are never deductible.

The one wrinkle in a simple formula is the word usually with the traditional IRA.

Contributions are fully deductible if neither you nor your spouse are covered by an employer-sponsored retirement plan. But if one or both are, then the contributions are either non-deductible or only partially deductible.

This leads nicely into the next difference…

Income Limits for IRA Contributions

The IRS has income limits, beyond which you’re not eligible to make a Roth IRA contribution at all.

The income limits for 2023 for Roth IRA contributions are as follows, and based on adjusted gross income (AGI):

• Married filing jointly, permitted to $230,000, phased out to $240,000, then no contribution permitted.

• Married filing separately, phased out to $10,000, then no contribution permitted.

• Single, head of household, or married filing separately and you did not live with your spouse at any time during the year, permitted to $146,000, phased out to $161,000, then no contribution permitted.

The income limits for traditional IRAs are loosely similar but work very differently. There are two sets of income limits.

The first applies if you’re covered by a retirement plan at work. It’s based on modified adjusted gross income or MAGI. It looks like this for 2024:

• Single or head of household, fully deductible up to $77,000, partially deductible to $87,000, then no deduction permitted.

• Married filing jointly or qualifying widower, fully deductible up to $123,000, partially deductible to $143,000, then no deduction permitted.

• Married filing separately, partially deductible up to $10,000, then no deduction permitted.

There’s a second set of income limits, also based on MAGI, if you’re not covered by an employer plan, but your spouse is:

• Married filing jointly, fully deductible up to $230,000, phased out up to $240,000, then no deduction permitted.

• Married filing separately, a partial deduction up to $10,000, then no deduction permitted.

If you exceed the income limits, you can still make a non-deductible traditional IRA contribution.

Income Limits for Roth IRAs

Roth IRAs have a different set of income limitations. They are as follows for 2024:

• Married filing jointly, fully deductible up to $230,000, partially deductible up to $240,000, then no deduction permitted.

• Married filing separately, fully deductible up to $10,000, then no deduction permitted.

• Single or head of household, fully deductible up to $146,000, partially deductible up to $161,000, then no deduction permitted.

One of the major differences between traditional and Roth IRAs is that once you reach the income threshold for a Roth IRA, no contribution is permitted at all.

No contribution is permitted for a Roth IRA if you exceed the income limits.

Taxability of Non-deductible Contributions

Roth IRA contributions are not tax-deductible, so withdrawals are not taxable. This works neatly within IRS ordering rules.

This applies specifically to Roth IRAs, and it enables you to make withdrawals based on the following priority:

1. IRA participant contributions

2. Taxable conversions

3. Non-taxable conversions

4. Investment earnings

This means the first withdrawals made from a Roth IRA are considered contributions and are therefore not taxable upon withdrawal.

It works like this…

You have $50,000 in a Roth IRA account. $30,000 are your contributions. The remaining $20,000 is accumulated investment earnings. You need to withdraw $15,000, and you’re under 59 ½.

Under IRS ordering rules, there will be no tax or penalties on the withdrawal, since the amount withdrawn is less than the $30,000 in plan contributions.

The withdrawal amount is considered to be a return of your contributions – and not tax deductible when made – and not subject to tax.

This arrangement is unique to the Roth IRA. No other retirement plan withdrawals, including traditional IRAs, have the same arrangement.

If you have a traditional IRA that includes non-deductible contributions, you can withdraw those funds without paying income tax on the distribution. However, the withdrawal will be subject to IRS Pro pro-rata rules.

It works like this…

You have $50,000 in a traditional IRA. It includes $30,000 in contributions, of which $5,000 were made with non-deductible funds. (The balance is tax-deferred investment income.). You withdraw $5,000 from your plan.

That means that out of the $5,000 you withdraw, $500 (10% of $5,000) will not be subject to tax. The remaining $4,500 will be fully taxable.

Taxability of Withdrawals

Here’s where we get to the part about Roth IRAs that everybody loves best, including me!

Withdrawals taken from a Roth IRA are completely tax-free, as long as you’re at least 59 ½, and have been in the plan for at least five years. This is the tax-free magic of the Roth IRA and its biggest single advantage.

The situation is very different with traditional IRA withdrawals, which are fully tax-deferred, but not tax-free.

The only exception is the withdrawal of non-deductible contributions, which are subject to the IRS pro-rata rules discussed above. Everything else – your tax-deductible contributions, and your accumulated investment earnings – are fully taxable upon withdrawal.

To give the simplest example possible, if you’re 59 ½, and have had a Roth IRA account for at least five years, you can withdraw $20,000 from the plan, and not have to pay a penny in income tax.

Under the same scenario, if you withdraw $20,000 from a traditional IRA, the entire amount must be included in your taxable income for the year of withdrawal (except the pro rata percentage made up of non-deductible contributions).

For most people, especially those with mature IRAs, that will be incredibly small.

Required Minimum Distribution (RMD) Rules – Definitely Different

This is another fairly simple topic in the Roth IRA vs traditional IRA analysis.

Required minimum distributions (RMDs) are a technique by which the IRS forces tax-deferred retirement money out of your plan, and onto your income tax return.

They are mandatory on all retirement accounts, including traditional IRAs, beginning when you turn 73.

Except for the Roth IRA.

Because distributions from a Roth IRA are not taxable, they are not subject to RMDs. This is a big advantage because it allows you to continue accumulating money in the plan, virtually throughout your life.

You may do this either to keep yourself from outliving your money or to leave a larger estate for your children.

RMDs are based on your remaining life expectancy at each age. Roughly speaking, about 4% of your retirement plans will need to be distributed when you turn 73.

The percentage will increase slightly each subsequent year, due to the fact that your life expectancy will be reduced going forward.

This is a consideration with traditional IRAs, but not with a Roth IRA.

Key Differences Between Traditional IRAs vs. Roth IRAs

Rollovers and Conversions

You can move funds into or out of Roth or traditional IRAs. For example, you can move funds from a 401(k) to either a traditional or Roth IRA.

With a traditional IRA, this is a rollover.

Generally speaking, it’s a transfer of funds between two retirement accounts that have equal tax treatment.

Funds moved from a 401(k) to a traditional IRA is a transfer between two tax-deferred accounts. The transfer can take place without tax consequences, which is why it’s a rollover.

You can similarly do a rollover from one Roth IRA account to another. But if you’re moving money from any other retirement plan, it’s a transfer of funds from plans that have unequal tax treatment.

Except in the case of a Roth 401(k), Roth 403(b), or Roth 457, you’re moving funds from a tax-deferred plan, to what will ultimately be a tax-free plan.

This has tax consequences.

Roth IRA Conversion Example

Moving funds from a traditional IRA or a 401(k) plan to a Roth IRA is referred to as a conversion because the rollover involves converting the funds from tax-deferred to tax-free.

In order to make the transfer, the funds coming out of a tax-deferred plan will be subject to ordinary income tax in the year of conversion.

Let’s say you move $100,000 from a 401(k) plan into a Roth IRA. The 401(k) is entirely tax-deductible contributions and accumulated investment earnings. 

If you move the entire balance to the Roth IRA in the same year, then you will have to include $100,000 in your taxable income. If you’re in the 25% tax bracket, this will result in a federal income tax of $25,000.

Once the funds have been converted, and the taxes paid, it will be a Roth IRA. Once you’re in the plan for at least five years, and at least 59 ½, you can begin taking tax-free withdrawals.

That last sentence describes why Roth IRA conversions are so popular, despite the immediate tax consequences.

You’re exchanging a tax liability now, for tax-free income in retirement. It’s what makes Roth IRAs perhaps the best retirement plan available.

Final Thoughts on the Roth IRA vs. Traditional IRA

So there you have it, two plans with similar names, but very little else in common.

Generally speaking, traditional IRAs are preferred if you’re currently in a high tax bracket, and expect to be in a much lower one in retirement. You’re getting the benefit of tax deferral at a high tax rate now, in exchange for a lower rate on distributions in retirement.

The Roth IRA is preferred if you don’t expect your tax bracket in retirement to be much lower than it is right now. You’re giving up tax deductibility now, in exchange for a tax-free income later.

Both plans have their virtues, but I’ll bet on the Roth IRA in most cases! If you’re looking for an account where you can open a Roth IRA, check out our guide on the best places to open a Roth IRA.

The post Roth IRA vs Traditional IRA: Understand the Difference appeared first on Good Financial Cents®.

Even if you never retire early, just knowing that you can is liberating!

And it may just be the strategy that frees you up to take on even bigger challenges in life.

That can happen when you reach the point where you no longer have to work for a living.

Can You Really Retire at 50?

It’s a big bold claim – retire at 50? Yeah, sure. A lot of people out there dream of early retirement – who wouldn’t love to hang up the office keys and jump off the 9-5 train sooner rather than later?

But while it’s possible to retire at 50 and have plenty of time left in life to have new experiences, it takes careful planning and a will of steel.

You’ll need to carefully manage your budget, invest in efficient high-yielding assets, and review the numbers regularly so you can work towards retiring at a reasonable age without sacrificing your lifestyle along the way.

So if you’ve got ambition and self-discipline, maybe you really can retire at 50!

Important Considerations if Retiring at 50 Is a Real Goal

If you want to retire at 50, there are some important considerations to take into account.

For starters, you’ll need a good grasp of money. That means understanding the stock market, planning for debt and savings, and investing in yourself through education or entrepreneurial ventures.

Just as important is managing your health – after all, no one wants to retire only to have their retirement cut short! Make sure you’re exercising regularly and eating a balanced diet.

And lastly, it never hurts to start visualizing what you want your life post-retirement to look like. It could be travel, starting up a business from home, or simply spending more quality time with loved ones.

When I was working with retirees, I would often ask them to share what a perfect day would look like for them in retirement. It really helps paint a clear picture of your future expectations for the next chapter in your life.

Whatever it is that lights your fire in the present moment will be a huge influence for not only deciding when you’re ready for retirement but how you plan on approaching that retirement once it’s here.

Looks now look at the 7 steps needed to retire at 50..

7 Steps to Retire at 50

1. Start Saving EARLY!

2. Save More than Everyone Else

3. Invest and Invest Aggressively

4. Maximize Your Retirement Savings

5. Set up a Roth Conversion “Ladder”

6. Live Beneath Your Means

7. Stay Out of Debt

There are all different ages that people want to retire at, and for most people, it’s probably something like as soon as possible! But let’s focus on how to retire at 50 since it’s a doable goal for a lot of people.

How can you make it happen?

Step 1: Start Saving EARLY!

If you’re 25 right now, then you should start saving to retire at 50 now – as in immediately. The best way to prove the point is with a couple of examples.

If you decide to put off saving to retire at 50 for another five years – when you are 30 – and you begin saving $10,000 per year, invested at an average annual rate of return of 7%, then by the time you’re 50 you will have $425,341.

But if instead, you decide to start saving right now – again, $10,000 per year, invested at an average annual rate of 7% – then by the time you are 50, you will have $656,227 saved.

That’s a difference of more than $230,000, just for beginning to save and invest five years sooner.

Step 2: Save More Than Everyone Else

It’s a common belief that you can retire just by saving 10% or 15% of your annual income. And that may be true, if you plan to retire at 55 or even 60, and have 35 or 40 years to save and invest money.

But if you’re serious about retiring at 50, you’re going to have to save more than anyone else. That might mean saving 20% of your income, or maybe 25% or even 30%.

Heck, if you’re much older than 25 or 30, you’ll have to save between 40% and 50% of your income if you hope to retire at 50.

What You Can Do Is Start Out Saving 20%.

But each time you get a pay raise or promotion with an even bigger pay raise, instead of spending the extra money, commit it to savings. After a few years of steady pay increases, you should be able to increase your savings rate to 30% or even more.

Saving such a large percentage of your income accomplishes two very important goals:

1. It obviously enables you to reach your savings goals faster

2. But just as important, it conditions you to living on less money than you earn

That second point will be really important when you actually do retire. The less money that you need to live on, the sooner and more effectively you’ll be able to retire.

Step 3: Invest and Invest Aggressively

I probably don’t have to tell you that you’re not going to be able to retire at 50 by investing in interest-bearing assets, like certificates of deposit. Interest rates of 1% per year or less just won’t cut it.

You’ll have to invest in stocks, and that’s where the great majority of your money will need to be invested at all times. The stock market has returned an average of between 9% and 11% over the past 90 years and that’s the kind of growth that you’ll need to tap into if you want to retire at 50.

Since you’re probably well under 50 now, you can afford to keep 80% to 90% of your savings invested in stocks. That’s the best way to get the kind of return on your investments that you’ll need to build the kind of portfolio you’ll need to make early retirement a reality.

All the rewards of aggressive investing come with some risk, so you want to make sure you invest with a solid platform.

Here are my top picks for all of you bold investors itching for early retirement:

• Ally Invest: With Ally Invest, you can opt for do-it-yourself investing or professional account management with Ally’s robo-advisor. Ally starts out by helping you establish your risk tolerance, where you can opt for “Aggressive growth” and put the majority of your investments into stocks.
  
  Ally Invest offers some of the lowest trading fees on the market, 24/7 customer service, and professionally managed portfolios to meet your investment goals. Try Ally Invest today.

• Betterment: Betterment offers investors an alternative robo-advising experience, completely automating your investment experience. The software maximizes your returns with tax loss harvesting and helps you reach your specific retirement goals with RetireGuide.
  
  The service automatically rebalances your portfolio to keep you on track to your goals. With a low annual management fee and no trade fees, you can start investing with Betterment easily.

• M1 Finance: Rather than assessing risk tolerance, M1 focuses on helping you target your investment goals and stay on track to reaching them. When you invest with M1 Finance, you can choose from 60 expertly designed investment “pies” made of up to 60 ETFs and stocks, or create your own.
  
  M1 then manages your investments, rebalancing your account as needed. M1 gives you fee-free account management and trades, and requires low initial investments, making it a great choice for aggressively investing for early retirement.

Open an Account

• Commission-free investing
• Allows fractional shares in stocks, ETFs
• Small minimum investment: $100

Step 4: Maximize Your Retirement Savings

Taxes are one of the underestimated obstacles of early retirement planning. Not only do they reduce the income you have available for savings, but they also take a chunk out of your investment returns.

For example, if you earn 10% on your investments, but you’re in the 30% tax bracket, your net return is only 7%. That will slow your capital accumulation.

But there is a way around that problem, at least partially. You should maximize your tax-sheltered retirement contributions.

Not only will that reduce your taxable income from your job, but it will also shelter the investment earnings in your investment portfolio so that a 10% return will actually be a 10% return.

If your employer offers a 401(k) plan, you should make the maximum contribution you’re allowed to. That would be up to $23,000 per year. If your employer offers a matching contribution, that’s even better.

You should also plan to make contributions to a traditional IRA, even if those contributions won’t be tax deductible due to income limitations. The investment earnings in the account will still accumulate on a tax-deferred basis, and that’s what you want to happen.

Now there is a basic problem with retirement savings, at least in regard to early retirement. If you begin taking withdrawals from your retirement accounts before you reach age 59 ½ you will not only be subject to income taxes on the withdrawals but also the 10% early withdrawal penalty as well.

But there’s a way around that dilemma – it’s the Roth IRA.

Step 5: Set up a Roth IRA Conversion “Ladder”

You don’t have to contribute to a Roth IRA every year in order to get the benefits of the Roth IRA. You can set it up by doing a Roth conversion from other retirement accounts, such as a 401(k) plan and a traditional IRA.

(That’s another big reason why you should always max out your retirement savings, especially if you want to retire at 50).

Roth IRAs enable you to take tax-free withdrawals from the plan once you reach age 59 ½, and have been in the plan for at least five years.

How Does That Help You if You Want to Retire at 50?

Roth IRAs Have a Loophole. Contributions to a Roth can be withdrawn free from taxes and the early withdrawal penalty.

After all, since there were no tax savings going in, there was no tax liability going out.

(Taxes and penalties, however, do apply to the earnings from the account, however, the contribution withdrawal rules don’t require a pro-ration between contributions and earnings the way traditional IRA withdrawals do.)

That contribution withdrawal loophole makes the Roth IRA perfect for early retirement. You can make this happen by doing a series of annual Roth IRA conversions from your other retirement accounts.

Are you with me so far?

There is one difference between contribution withdrawals from a regular Roth IRA and a Roth conversion. Since you are not making direct contributions with Roth conversions, but rather converting balances from other accounts, the IRS has a five-year rule on early withdrawals.

You can avoid this by making a series of annual conversions to a Roth IRA, in what is known as a Roth conversion ladder.

Basically, what you do is decide how much money you will need to live on when you retire, and then convert that amount each year for five years.

As long as you stay five years ahead, you will always have a sufficient amount of Roth funds to live on, and you can withdraw them free of both income taxes and penalties.

To illustrate, your Roth conversion ladder will look like this

The Roth conversion ladder will enable you to make early withdrawals from your Roth account until you are 59 ½ and can begin making penalty-free withdrawals for your non-Roth retirement accounts. It will also prevent you from having to draw down non-retirement accounts.

There is one downside to the Roth conversion ladder, which is a problem with all forms of Roth conversions, and that’s that you will have to pay regular income tax on the number of retirement assets converted to a Roth IRA.

But that may be a price worth paying if it means you’ll be able to have a generous early retirement income to go with that early retirement.

Step 6: Live Beneath Your Means

One financial habit you’ll have to get into is to live beneath your means. That means that if you earn a dollar after taxes, you’ll have to live on say, 70 cents, and bank the rest.

That’s not an easy pattern to get into if you’ve never done it before, but it’s absolutely necessary. Unless you can master it then early retirement will be nothing more than a pipe dream.

In order to live beneath your means you’ll have to adopt a few strategies:

• Keep your basic living expenses low, especially your housing expense

• Drive an older car, one that isn’t expensive and doesn’t require you to go into debt

• Be proactive about finding bargains on whatever you buy – food, clothing, repairs, insurance, etc.

• Be conservative with entertainment, including and especially with vacations and traveling – early retirement planning and the good life don’t mix well

• Avoid eating out all the time – it’s a slow way to torpedo your long-term plans

Any money that isn’t going into living expenses is more money for savings.

Step 7: Stay Out of Debt

A word of warning about debt: it can undo everything you’re trying to accomplish in order to retire at 50.

It will do you little good if you reach 50 and have $500,000 saved, but $100,000 in debt of various types (it’s easier to get to that level than you think – just live the TV version of the suburban lifestyle and it’ll happen all by itself!).

Not only does debt weaken your net worth, but it also comes with monthly payments. And you’ll need as few of those as possible if you’re going to retire at 50.

Better yet, the goal should be to be debt-free entirely.

Debt not only raises the cost of living in retirement, but it will reduce the amount of income you’ll have to dedicate to savings between now and then.

Being debt-free should include your mortgage if you own your own home or plan to. Your early retirement plan should include a sub-plan to pay off your mortgage in time for your retirement date.

Nothing goes better with early retirement than a mortgage-free house!

Yes, You Can Retire at 50

As you can see, if you really want to retire at 50 you’ll have to adopt a multi-strategy plan to make it happen. It’s mostly about saving a lot of money and investing it well, but there are a lot of factors that will make that challenge more doable.

Make a plan now, and then stick to it religiously, and you’ll be able to retire at 50 – or any other age you choose.

Retiring at 50 – The Ultimate Guide

Retiring at 50 may sound intimidating, but it is a goal that many people can reach with the proper planning. To retire comfortably at 50, it is important to create a retirement plan that takes into account future financial obligations and then start investing early.

Setting realistic goals and analyzing investments on a regular basis can help ensure that you are on track for your retirement goals. Additionally, semi-retirement or “bridge jobs” can provide an option to continue working while still having time for leisure activities.

Review our list of side hustle ideas for options to supplement your income after retirement.

With these strategies, retirees can gain confidence in their ability to achieve financial independence at an earlier age.

What Investments Should I Consider if I Want to Retire at 50?

If you are planning to retire at 50, there are certain investments that you should consider. Long-term investments such as stocks, bonds, ETFs and annuities can provide a steady stream of income over time.

It is important to diversify your portfolio so that you don’t have all your money tied up in one investment.

Additionally, investing in real estate will increase your wealth over time (if you have the stomach for it). It’s also a MUST to have an emergency fund in case of unexpected expenses such as healthcare bills.

Are Annuities a Good Investment if I Want to Retire at 50?

Annuities are a viable investment option for those seeking to retire at 50. They provide a steady stream of income that generally continues even after retirement age.

Annuities can also be tailored to meet an individual’s needs, such as providing a set amount of money each month or lump sum payments at predetermined intervals.

However, the amount of money you get from the annuity is usually based on the amount of money you put into it and can vary depending on the type of annuity chosen.

Be also careful on the type of annuity you purchase. There are so many different annuity options that many investors get confused on which one is best for them.

The Bottom Line – How to Retire at 50 in 7 Easy Steps

The aspiration to retire at 50 is not a mere pipe dream but a feasible objective with the right blend of meticulous planning, disciplined saving, and astute investing.

The liberation that comes with the possibility of early retirement can spur individuals to embrace grander challenges in life.

The outlined 7-step strategy highlights the necessity of commencing savings at an early age, investing aggressively, and cleverly navigating tax shelters to amass a retirement corpus.

While maneuvering a Roth IRA conversion ladder could mitigate tax implications and penalty fees, living beneath one’s means emerges as an imperative practice to fast-track the journey towards a leisurely and financially secure retirement at 50.

The advent of reliable investment platforms like Ally Invest, Betterment, and M1 Finance further facilitates individuals in meticulously crafting and managing their investment portfolios toward achieving this coveted milestone.

The post How to Retire at 50 in 7 Easy Steps appeared first on Good Financial Cents®.

Regularly checking your 401(k) account can help you stay on top of your investments and make sure that your money is working for you in the best way possible.

What Is a 401(k)?

A 401(k) is a type of retirement savings plan offered by many employers to their employees. It is a tax-advantaged savings plan that allows employees to set aside money from their paycheck on a pre-tax or after-tax (Roth) basis into an individual account established in their name.

The money in the account is invested and grows over time, and the employee can use the money in the account during their retirement years.

Employers may also choose to match a portion of the employee’s contributions, which can provide an additional incentive for employees to participate in the plan.

The 401(k) plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA) and are administered by the Employee Benefits Security Administration (EBSA).

The 401(k) plans have contribution limits set by the government (see 401(k) annual contribution limits here), and the money in the account is typically invested in a variety of investment options, such as ETFs, mutual funds, stocks, and bonds.

Withdrawals from the account before age 59 1/2 may be subject to penalties and taxes, but after reaching the age of 59 1/2, the employee can start withdrawing money without penalties. There are special rules that allow you to withdraw at age 55 if you retire early.

401(k) plans have become extremely popular in the U.S. and for good reason – they offer an excellent way to save for retirement and have virtually replaced the pension.

Why Is It Important to Check Your 401(k)?

It is important to check your 401k regularly because it is the primary way many save for retirement.

Investing in a 401k allows you to take advantage of tax-deferred growth, meaning you won’t pay taxes on any earnings or contributions until you withdraw the funds.

Most employers will provide online access to your 401(k) account, where you can check the performance of your investments and make adjustments as necessary.

Additionally, if you are changing jobs or retiring, checking your 401(k) is a must so that you understand exactly how much money you have saved and what options you have for managing it in the future. Especially if you plan on rolling over your 401(k) to an IRA.

It’s also important to monitor your investments and rebalance them as needed to ensure your savings are properly invested for long-term growth. Life will throw plenty of curveballs at you, and your financial goals will often have giant hurdles to overcome.

Don’t get discouraged—each setback is an opportunity for you to learn, grow, and come back stronger. You must have a vision for your future and strive to make it a reality.

Checking your 401k routinely can also help you track progress toward financial goals such as retirement saving milestones and your other aspirations.

Why You Need to Check Your 401k Frequently

How Often Do You Need to Check Your 401k?

It’s generally recommended to check your 401(k) account at least once a quarter or four times a year. This allows you to keep an eye on your account balance, investment holdings, contributions, and performance and make any necessary adjustments to your investment strategy.

However, some experts recommend that you check your account monthly or even more frequently, especially if you are nearing retirement or making significant changes to your investment strategy.

All are good suggestions on how often to check your 401k. Whatever you do, please know this:

Additionally, it’s a good idea to review your account statements as soon as you receive them to ensure that all of the information is accurate and to check for any errors.

If you notice any discrepancies or have any questions, it’s important to contact your plan administrator or financial advisor as soon as possible.

What if You Have Multiple 401(k) Accounts?

If you have multiple 401(k) accounts, it’s important to keep track of each one.

Empower is a financial management tool that allows you to track all of your financial accounts, including 401(k)s, in one place.

By linking your 401(k) account to Empower, you can view your account balance, investment holdings, contributions, and performance, as well as get a holistic view of your overall financial situation.

Once you link your 401(k) account to Empower, you can check your account balance and investment performance in real-time and track your progress toward your retirement goals.

Sign Up for Free

Use their Fee Analyzer to find hidden fees The app is 100% free See all your money accounts in one place, in real-time

Can’t Find Your 401(k) Online?

Checking your 401(k) account balance is an important step in tracking your retirement savings progress. If you are unable to find your account balance online, checking your most recent statement can be a useful option.

A 401(k) statement is a document that outlines the details of your account, including your balance, contributions, investments, and any fees or expenses associated with the plan.

The statement typically covers a specific period, such as a quarter or a year, and is sent to you either electronically or through the mail.

To find your account balance on your statement, look for the section that shows the summary of your account. Reviewing your statement regularly can help you stay informed about your 401(k) account and ensure that you are on track to meet your retirement goals.

Your 401k may also use an online portal to access your portfolio, keep track of changes in investments, and look over any fees associated with the plan.

These portals can also provide educational resources and analysis tools to help you better understand your financial situation and make more informed decisions about how to manage your 401k money.

Here’s an example of Vanguards’s online portal:

Contact Your 401(k) Administrator

If you are unable to find your 401(k) account balance online or through your statement, calling your plan provider’s customer service number can be a useful option. A representative can access your account information and provide you with your balance over the phone.

To get the information you need, you may need to provide some personal identification information to confirm your identity.

Keep in mind that some plan providers may charge a fee for phone inquiries, so it’s important to check if there are any fees before making the call.

It’s also a good idea to check the accuracy of the balance provided by the representative by comparing it with your most recent statement or online account summary.

Regularly checking your 401(k) account balance can help you stay informed about your retirement savings and make any necessary adjustments to your contributions or investments.

The Bottom Line on Checking Your 401(k)

You’ve worked hard and saved for the future, so it’s important that you stay on top of your 401(k) investment. Checking in with your 401k occasionally can help ensure that you’re getting the most out of it.

Simple steps like reviewing quarterly statements, rebalancing regularly, maintaining the right mix of investments, and autopilot investing can help you keep tabs on how your retirement funds are doing without having to focus on it all the time.

It’s also important to remember to review other fees charged for managing or balancing a 401(k) – extra charges over time can really add up.

Knowing what to look for is key when checking your 401k – staying informed will help make sure you get the most out of your retirement savings.

The post How to Check Your 401(k) Balance appeared first on Good Financial Cents®.

With Roth contributions, taxes will be taken from the money prior to placing it in the plan, but it can then be withdrawn tax-free once you retire.

Making the correct decision depends on a few factors, such as your current and expected future income levels, how much of an earning potential you have left before you retire, and also how close you are to retirement age.

When considering all aspects of these two types of contributions it could result in potentially thousands more dollars during retirement, so it’s important to take the time to research each option thoroughly.

Pre-tax and Roth (after-tax) contributions are two different types of contributions that can be made to retirement accounts such as 401(k)s and IRAs.

Both pre-tax and Roth contributions have their advantages and disadvantages, and the choice between them will depend on your personal financial situation and goals.

Factors to consider include your current tax bracket, your expected tax bracket in retirement, and whether you prefer to pay taxes now or later.

401(k) and Roth 401(k) Contribution Limits

What Factors Do You Need to Consider to Choose After-Tax vs Pre-tax?

When deciding between after-tax and pre-tax options, there are a few factors to consider.

First, you need to consider your current tax bracket. If you’re in a higher tax bracket, then it might make more sense financially to choose the pre-tax option as it provides additional tax benefits due to being taxed at a lower rate.

Second, if you expect your income or tax rate to increase in the future, then investing in pre-tax accounts may be beneficial since they can defer taxes until withdrawal time when your tax rate is likely higher.

Third, it’s important to think about what type of investments you plan to make and how long you’re willing to wait before withdrawing funds from those investments.

Some investments and retirement accounts have restrictions on when the funds can be withdrawn and penalties for early withdrawals so it’s important to consider these factors as well.

Finally, if you plan to use the invested money for short-term needs such as an emergency fund or home repairs, then after-tax options may be more suitable since they don’t require waiting for certain periods of time before being able to access the funds.

What Are the Tax Advantages of an Investor Contributing Pre-tax or Roth Contributions to Their 401K if They Are 35 Years Old and Making $100,000 per Year?

If an investor is 35 years old and making $100,000 per year, the tax advantages of pre-tax and Roth contributions to their 401(k) will depend on their current tax bracket and their expected tax bracket in retirement.

It’s important to note that the above examples are based on current tax laws and tax rates could change in the future and an investor should consult with a tax advisor to understand the tax implications of their contribution decisions.

Additionally, it’s always a good idea to consult with a financial advisor to determine which option is best for you and the best way to balance the tax savings and tax-free withdrawals in retirement.

Assuming the Money in the 401K Would Grow at 8% Compounded Annually, What Would the Tax Benefit Be After 30 Years?

Assuming the money in the 401(k) would grow at 8% compounded annually, the tax benefit of pre-tax and Roth contributions would be different after 30 years.

It’s important to note that these examples assume that the investor continues to contribute the same amount every year and that tax laws and tax rates will remain the same over the next 30 years.

It’s always a good idea to consult with a tax advisor or financial advisor to understand the tax implications of contributions and withdrawals, as well as the best way to balance the tax savings and tax-free withdrawals in retirement.

Pros and Cons of Pre-Tax 401k vs Roth Contributions

Pros of Pre-Tax 401k Contributions:

• Contributions are made with pre-tax money, meaning you do not pay taxes on your contributions until you make withdrawals.

• This can reduce your overall tax liability in the current year.

• The employer usually matches a certain percentage of employee contributions, so it is essentially free money that should be taken advantage of.

Cons of Pre-Tax 401k Contributions:

• The money is subject to taxes when withdrawn, which may result in an unexpectedly high tax bill at retirement.

• Withdrawing funds before age 59 1/2 comes with a 10% penalty fee as well as income taxes.

• Your taxable income for the current year might be too low to take full advantage of all available deductions and credits.

Pros of Roth 401k Contributions:

• Contributions are made with post-tax dollars, so there are no taxes due at withdrawal or retirement.

• Withdrawals can be taken out penalty-free after age 59 1/2.

• Funds grow tax-free over time, allowing for maximum long-term growth.

Cons of Roth 401k Contributions:

• You don’t get any immediate tax benefits since you are paying taxes upfront on your contributions.

• There is usually no employer match on contributions, so it’s up to you alone to fund the account.

• In some cases, if you make too much money or have too large a contribution amount, you may not qualify for the Roth 401k option at all.

The Bottom Line on Pre-tax vs After-Tax Contributions

Pre-tax vs. Roth (after-tax) contributions are an important distinction to make when you are planning for retirement.

Pre-tax contributions give you a tax break now, but you will pay taxes on the withdrawals later. Roth contributions require that you pay taxes on the contribution now, but your future withdrawals will be tax-free.

Both types of contributions have their own advantages and disadvantages based on your individual financial situation. It is important to understand both options so you can make the most of your retirement savings.

Consult with a financial planner if you need more guidance on which type of contribution will work best for you.

The post Pre-tax vs Roth (After-Tax) 401(k) Contributions appeared first on Good Financial Cents®.

A SIMPLE IRA sounds “simple” to set up, but is it really that easy? And how does it compare to the 401k and other retirement plans that exist? We’ll answer that and more as we take a deep dive into the SIMPLE IRA rules and limits.

What Is a Simple IRA?

A SIMPLE IRA, or Savings Incentive Match Plan for Employees, is a type of employer-sponsored retirement savings plan that is designed to be easy to set up and maintain for small business owners.

It offers a way for employees to save for retirement on a tax-deferred basis while also requiring employers to make contributions on behalf of their employees.

Benefits of the SIMPLE IRA vs 401k

One of the main benefits of a SIMPLE IRA is that it is easy for small business owners to set up and maintain.

Additionally, the plan requires minimal paperwork and has relatively low administrative costs.

Benefits of the SIMPLE IRA

Another key benefit of a SIMPLE IRA is that it allows employees to make contributions to the plan on a pre-tax basis. This means that the money employees contribute to the plan is not subject to income taxes until it is withdrawn in retirement.

This can help employees save money on their taxes in the short term while also allowing them to save for retirement in the long term.

Employers are also required to make contributions to a SIMPLE IRA on behalf of their employees.

The employer must either match employee contributions dollar for dollar up to 3% of compensation or make a non-elective contribution of 2% of compensation for all eligible employees.

This can be a great incentive for employees to save for retirement and a way for small business owners to attract and retain talented employees.

7 Things You Should Know About the SIMPLE IRA

1.  Your Employer’s Contributions Are 100% Vested

With most 401(k)s, you must work for the employer for a certain number of years to be vested.  This means if you were to leave that employer, you could take that employer’s matching contribution with you. 

But with the 401(k), you have anywhere from three to five years before you’ve satisfied the 401(k) vesting schedule, which is different with SIMPLE IRA.

With the SIMPLE IRA, you are 100% vested whenever the employer deposits that into your account.

This is definitely a huge difference from the 401(k). Both you and any employees you have enjoy immediate vesting, not only of your own contributions to the plan but also of matching contributions on the employer side.

2. Employers Have to Match in a SIMPLE IRA

Each year, the employer is required to make a contribution to your SIMPLE IRA account, whether it be in the form of a match or what’s called a non-elected contribution.  Matching contribution states that the employer has to match at least what you match. 

So, if you’re matching 3%, the employer has to match 3% as well.  Note that 3% is the most that the employer has to match, which could be considerably different than compared to a 401(k).

The employer does have the option to reduce the matching amount to 1% for two of a five-year period.  What that means is that if the employer does do this, they have to match the full 3% for the remaining three of those five years. 

The calculation can be a little tricky, but know that your employer is matching no matter what.

If the employer chooses not to match, they may make a “non-elect contribution”. That means they will contribute 2% of your salary.  Even if you are contributing 3% of your salary, they will only contribute 2%.

3. Employees Control the Investments

With most 401(k)s, you are limited to the investment options that your employer provides you.  This is considerably different when compared to the SIMPLE IRA.  Being a self-employed retirement plan, the SIMPLE IRA gives you the discretion of what exactly you want your money invested into. 

If you want to buy individual stocks, mutual funds, ETFs, or CDs, you are allowed.  This is the same feature that a SEP IRA offers.

The investment control factor plays out in two ways:

• Employee Choice of Investment Trustee. You can designate the plan so that the employee chooses his or her own financial institution to hold the plan. That not only gives a greater choice to the employees, but it also relieves you, as the employer, of the burden of managing the entire plan for everyone.

• Self-Directed Investing. Participants not only choose the financial institution, but they are also free to engage in do-it-yourself investing. That means they can choose how the money is invested, where it’s invested, as well as the level of risk that they are willing to assume.

4. Employees Can Contribute 100% Of Their Income to a SIMPLE IRA

You are allowed to contribute up to $16,000 in 2024, up from $15,000 in 2023, per year in a SIMPLE IRA.  If you’re over the age of 50, you’re allowed a catch-up contribution, which increased to $3,500. 

Please note that the $16,000 (or $19,500) is far less than the amount that you are eligible to contribute to a 401(k).

Nor is it as high as the (up to) $69,000 that you could contribute to either a SEP IRA or a Solo 401(k).

But the SIMPLE IRA contribution limit is more than two times as high as the contribution limit for a traditional or Roth IRA. And the contribution limit for people 50 or older is almost 2 ½ times higher than the $8,000 limit for traditional and Roth IRAs.

The 100% feature of the SIMPLE IRA means that the employee can contribute virtually all of their income to the plan, up to the maximum contribution.

That means that if an employee earns $30,000, they can contribute the first $16,000 of their income into the plan (or $19,500 if they’re 50 or older). There is no percentage limitation on the contribution, only the dollar amount.

Yes, it’s true that you can contribute more to other plans, like the SEP-IRA or the Solo 401(k). However, your business will have to have a relatively high income to reach those levels since both are percentage-based.

But if your self-employment income is less than $100,000 per year, you might find the simplicity of the SIMPLE IRA to be the better choice for your business.

For example, SIMPLE IRAs don’t require filing special reports with the IRS. They also aren’t subject to discrimination and top-heavy testing. It’s more of a group IRA than anything else. And for a small business, simplicity is a definite advantage.

5. SIMPLE IRAs Do Not Allow Loans

A lot of 401(k)s have loan provisions that allow the employee to borrow against their money if need be.  With SIMPLE IRAs, this is not the case.  Keep that in mind if you’re thinking that this might be a last resort place to draw money out.

The reason this is true is that a SIMPLE IRA is, first and foremost, an IRA. And just as you cannot borrow money from a traditional or a Roth IRA, you also can’t borrow from a SIMPLE IRA.

That’s probably not a bad thing, either. The most important function of any retirement plan is to give you the ability to create a tax-sheltered investment portfolio for your retirement.

Since you won’t be able to borrow against a SIMPLE IRA, you’ll be forced to keep the plan for its primary intended purpose.

6. The SIMPLE IRA Two-Year Rule

This is something that should definitely be noted within the SIMPLE IRA.  Most retirement plans — 401(k)s, regular IRAs, Roth IRAs, etc. — have a 10% early withdrawal penalty if under the age of 59.5.  But with the SIMPLE IRA, it takes it one step further.

If the SIMPLE IRA that you’ve started is less than two years and you cash it out, instead of the normal 10% penalty, you will be subject to a 25% penalty in addition to ordinary income tax.

Do not overlook this.  Keep in mind that doesn’t apply to just cashing it out.  If you were attempting to rollover your SIMPLE IRA into a rollover IRA, the 25% penalty would apply as well.  Remember to just wait the two years before converting into either a regular IRA or cashing it out.

7. The 2024 Contributions Have Increase

The contribution limit for 2024 increased to $16,000. The catch-up contribution limit also increased to $3,500. That means that somebody who turns 50 in the year 2023 or 2024 and has access to a SIMPLE IRA can contribute a total of $19,500.

7 Things You Should Know About the SIMPLE IRA

Setting Up a SIMPLE IRA and Maintaining Filing Requirements

Setting up a SIMPLE IRA is only a little bit more complicated than setting up a traditional or Roth IRA. You start by selecting a financial institution (which we’ll cover below) and then following three steps:

1. Execute a written agreement to provide benefits to all eligible employees
2. Give employees certain information about the agreement
3. Set up an IRA account for each employee

The written agreement can be completed using IRS Form 5304-SIMPLE or IRS Form 5305-SIMPLE. (5304 is used if each participant will choose their own financial institution. A 5305 is used if you will designate the financial institution for the entire plan).

Neither form is required to be filed with the IRS, but you should keep a completed copy of the form on file, including all relevant signatures. You could also use a pro forma provided by the financial institution that you will be using to hold the plan. It will accomplish the same purpose.

You’ll need to provide an annual notice to eligible employees at the beginning of the election period (or provide each with a copy of either the completed 5304 or 5305 form). That will notify each employee of the following:

1. The employee’s opportunity to make or change a salary reduction choice under the SIMPLE IRA plan;
2. The employees’ ability to select a financial institution that will serve as trustee of employees’ SIMPLE IRA, if applicable;
3. Your decision to make either matching contributions or nonelective contributions;
4. A summary description (the financial institution should provide this information); and
5. Written notice that the employee can transfer his or her balance without cost or penalty if you are using a designated financial institution.

The plan must be set up by or for each eligible employee, and all contributions to the plan must go into it. The plan must be established between January 1 through October 1 of the year. Unfortunately, a SIMPLE IRA cannot have a Roth provision, as would be possible with a 401(k) plan.

Pros and Cons of a Simple IRA

If you’re considering a SIMPLE IRA for your business, here’s a breakdown of the pros and cons of setting it up versus another retirement plan:

Where Can I Open a SIMPLE IRA?

A SIMPLE IRA can be opened through a wide number of potential trustees. These can include banks, investment brokerage firms, mutual fund families, and managed investment account brokers. The process is easy and comparable to opening up either a traditional or a Roth IRA.

For whatever reason, there are fewer investment brokerage firms that accept SIMPLE IRA plans than other types of IRAs, like traditional, Roth, rollover, and even SEP plans. Below are two investment brokers that we have reviewed (or used) and recommend as a trustee for your plan.

TD Ameritrade

We’ve done a full review of TD Ameritrade and recommend it as a good trustee for a SIMPLE IRA plan. Like many other large brokers, they’ve eliminated trading fees on stocks, exchange-traded funds (ETFs), and options.

And they have a strong IRA capability in general. They’re a diversified broker, offering stocks, options, mutual funds, ETFs, futures, Forex, bonds, and even certificates of deposit.

Not only do they have excellent customer service, but they also have more than 100 branches located nationwide, in case you prefer face-to-face contact.

They also have a Retirement Calculator tool that analyzes your personal information, goals, income, assets, and risk tolerance and then shows you how to reach your goals, as well as track your progress.

They also offer more than 100 ETFs that you can trade for free. All around, TD Ameritrade is an excellent platform to host a SIMPLE IRA plan or any other type of IRA account.

E*TRADE

We’ve also reviewed E*TRADE, and in doing so, we’ve rated it as the best investment platform for active traders. The platform offers free independent research, streaming real-time quotes, customizable planning tools everything that you need for do-it-yourself investing.

At $0 per trade, they’re one of the best in the industry on pricing. But they also offer more than 2,700 no-load, no transaction fee mutual funds. And since they offer virtually every other type of investment or retirement plan, you can use E*TRADE to hold all of your accounts with one brokerage.

E*TRADE is well recognized in regard to customer service, which can be reached by phone 24 hours a day. They also offer as much or as little account assistance as you need.

And if you want a fully managed account, E*TRADE offers that through their E*TRADE Capital Management arm. That will even enable you to have your SIMPLE IRA plan split between a self-directed portion and a professionally managed portion.

The Bottom Line on the SIMPLE IRA

The SIMPLE IRA can be a great option for small business owners and their employees. It offers an easy and low-cost way for employees to save for retirement on a tax-deferred basis while also requiring employers to make contributions on behalf of their employees.

If you are a small business owner or an employee, it’s worth considering a Simple IRA as part of your retirement savings strategy.

The post 7 Things You Need to Know About a SIMPLE IRA for 2024 appeared first on Good Financial Cents®.

Contributions to a Roth IRA are made with after-tax dollars, which means your money can grow tax-free. When you’re ready to take distributions from your Roth IRA in retirement (or after age 59 ½), you won’t pay income taxes on your distributions, either.

If you want to start contributing to a Roth IRA as part of your retirement strategy, keep in mind there are some limits. For example, if you’re under the age of 49 you can contribute a maximum of $7,000 for the 2024 tax season. 

Interested in learning more about the specifics of the Roth IRA? Here’s everything you need to know.

What Is a Roth IRA?

A Roth IRA is a type of individual retirement account (IRA) that allows you to save money for retirement on a tax-deferred basis. With a Roth IRA, contributions are made with post-tax dollars and qualified withdrawals are tax free.

This means that the amount you contribute will not be subject to taxes today and any withdrawn amount when you reach retirement age, including earnings, can be taken out tax free.

And in case you missed that last point, it’s worth repeating:

How Much Can You Contribute to a Roth IRA?

For the 2024 tax season, standard Roth IRA contribution limits increased from last year, with a $7,000 limit for individuals. Plan participants ages 50 and older have a contribution limit of $8,000, which is commonly referred to as the “catch-up contribution.” 

You can also contribute to your IRA up until tax day of the following year.

What You Need to Know About Roth IRAs

Here’s the thing about opening a Roth IRA: not everyone can use this type of account. We’ve included a few important Roth IRA rules you need to know about below.

Fund Distributions 

Roth IRA accounts come with a few unique benefits outside of future tax savings. For example, you don’t have to take Required Minimum Distributions (RMDs) out of a Roth IRA at any age, and you can leave your money in your account for as long as you live.

You can also continue making contributions to a Roth IRA after you reach age 70 ½ provided you earn a taxable income that’s below Roth IRA income limits.

Roth IRA Income Limits

Not everyone can contribute into a Roth IRA account due to income caps. There are income guidelines that must be followed —  it’s even possible to have an income so high you can’t use a Roth IRA at all.

If your taxable earnings fall within certain income brackets, your Roth IRA contributions might be “phased out”. This means you can’t contribute the full amount toward your Roth account. 

Here’s how Roth IRA income limits and phase-outs work, depending on your tax filing status.

Married Couples Filing Jointly:

• Couples with a modified adjusted gross income (MAGI) below $218,000 can contribute up to the full amount.

• Couples with a MAGI between $218,000 and $227,999 can contribute a reduced amount.

• Couples with a MAGI of $228,000 or more can’t contribute to a Roth IRA.

Married Couples Filing Separately:

• Couples with a MAGI below $10,000 can contribute a reduced amount.

• Couples with a MAGI of $10,000 or more can’t contribute to a Roth IRA.

Single Tax Filers:

• Single tax filers with a MAGI below $138,000 can contribute up to the full amount. 

• Single tax filers with a MAGI between $138,000 and $152,999 can contribute a reduced amount.

• Single tax filers with a MAGI of $153,000 or more can’t contribute to a Roth IRA.

Retirement Account Conversions Allowed

If you have another type of retirement account, like a traditional IRA or even a workplace 401(k), it might be tempting to convert this account into a Roth IRA. This is known as a Roth IRA conversion which requires you to pay income taxes on your distributions now so you can avoid income taxes later on.

Although that might sound aggressive and unnecessary, there are many scenarios where a Roth IRA conversion can make sense. For example, let’s say you’re not earning a lot of money in a specific year and you want to convert to a Roth IRA while paying an extremely low tax rate. You could fork over the taxes now and avoid paying income taxes on distributions later in life when you’re taxed at a higher rate.

As mentioned earlier, Roth IRA accounts don’t require you to take a minimum distribution while you’re alive. Moving your money into a Roth IRA can make sense if you don’t want to be forced into required minimum distributions (RMDs) like you would with a traditional IRA or a 401(k) at age 72. 

With a Roth IRA conversion, you’d create an opportunity where your money could grow and compound, untouched, for a much longer stretch of time.

IRA Recharacterization

A recharacterization takes place when you move money from a traditional IRA to a Roth IRA, or from a Roth IRA to a traditional IRA. More specifically, recharacterization changes how specific contributions are designated depending on the type of IRA.

For example, maybe you believed your income would be too high to contribute to a Roth IRA in a specific year but found your income was actually low enough to contribute the full amount. If you already contributed to a traditional IRA, a recharacterization could help you move your funds into a Roth IRA, after all.

Of course, the opposite is also true. You might’ve thought your income qualified you to contribute to a Roth IRA but at the end of the year, you found out you were wrong after already making Roth contributions. In that case, a recharacterization to a traditional IRA could make sense.

These moves can be complicated, and there might be significant tax consequences along the way. It’s best to consult with a financial advisor or tax specialist before changing the designation of your IRA contributions and face potential tax consequences.

Early Withdrawal Penalties

You can withdraw your Roth IRA contributions at any time without penalty. Also, you can withdraw contributions and earnings 59 ½ and older, if you’ve had the Roth IRA account for at least five years. This is considered a qualified disbursement that won’t incur early withdrawal penalties. 

But there are downsides if you need to withdraw your earnings ahead of retirement age. If you choose to withdraw your Roth IRA earnings before age 59 ½, you’ll face a 10% penalty. Some exceptions apply, though. 

For example, you can withdraw earnings from your Roth IRA account without paying a penalty if you’ve had the account for at least five years, and you qualify for one of these exemptions:

• You Used the Money for a First-Time Home Purchase,

• You’re Totally and Permanently Disabled, Or

• Your Heirs Received the Money After Your Death.

What’s the Difference on Roth IRAs vs Traditional IRAs?

The main difference between Roth IRAs and Traditional IRAs is their tax structure. Contributions to Traditional IRAs are made with pre-tax money and withdrawals are taxed at the individual’s current income tax rate, while contributions to Roth IRAs are made with after-tax money, but withdrawals are tax free.

Another key difference is that Roth IRA contributions can be withdrawn at any time without penalty, while Traditional IRA contributions may incur a 10% early withdrawal penalty before age 59 1/2. Additionally, there are differences in contribution limits and eligibility requirements for each type of IRA.

Key Differences Between a Traditional IRA vs a Roth IRA

Where to Get Help Opening a Roth IRA Account

If you feel like a Roth IRA is the best retirement vehicle for goals, you can open a Roth IRA account with almost any brokerage account. But they don’t all offer the same selection of investments to choose from. Some brokerage firms also offer more help creating your portfolio, and some charge higher (or lower) fees.

That’s why we suggest thinking over the type of investor you are before you open a Roth IRA. Do you want help creating your portfolio? Or do you want to select individual stocks, bonds, mutual funds, and ETFs and create your own?

Always check for investing fees as you compare firms, and the types of investments each account offers. We did some basic research for you to come up with a list of the best brokerage firms to open a Roth IRA.

Open a Roth IRA Account

• Commission-free investing
• Allows fractional shares in stocks, ETFs
• Small minimum investment: $100

Bottom Line on Roth IRA Rules and Limits

Opening a Roth IRA is a great idea if you want to avoid taxes later in life, but you’ll want to start sooner rather than later if you hope to maximize this account’s potential. Remember that all of the money you contribute to a Roth IRA can grow tax-free over time.

Getting started now lets you leverage the power of compound interest to the hilt. Before opening a Roth IRA account, compare all of the top online brokerage firms to see which ones offer the investment options you prefer at fees you can live with.

Also consider which firms offer the type of help and support you need, including the option to have your portfolio chosen for you based on your income, your investment timeline, and your appetite for risk.

Roth IRA Rules FAQs

The post Roth IRA Rules and Contribution Limits for 2024 appeared first on Good Financial Cents®.

Recently a reader sent in this question about it:

Thanks for your questions, Debbie! Before we answer your question, let’s do a quick refresher on the Roth IRA rules.

What Is a Roth IRA?

A Roth IRA is a type of individual retirement account (IRA) that allows you to contribute after-tax money and withdraw it tax-free in retirement. It is named after Senator William Roth, who sponsored the legislation that created the account. Now I don’t know personally know Senator Roth – but this man deserves an award for creating the greatest savings tool ever!

The main difference between a Roth IRA and a traditional IRA is the way they are taxed. Contributions to a traditional IRA may be tax-deductible, but withdrawals in retirement are taxed as ordinary income. With a Roth IRA, contributions are not tax-deductible, but withdrawals in retirement are tax-free.

What Are the Benefits of a Roth IRA?

Roth IRAs have a number of benefits, including:

• Tax-Free Growth: The money in your Roth IRA grows tax-free, which can result in a larger balance over time.
• Tax-Free Withdrawals: Withdrawals from a Roth IRA in retirement are tax-free, which can be a significant advantage if you expect to be in a higher tax bracket in retirement.
• Flexibility: You can withdraw your contributions (but not any earnings) from a Roth IRA at any time without penalty.
• No RMDs: Unlike traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) during the account holder’s lifetime.

There are some income limits and contribution limits for Roth IRAs, and you may not be eligible to contribute if your income is too high.

Can You Lose Money in a Roth IRA?

Yes, you absolutely can. You first need to understand the Roth IRA is NOT an investment. It’s an investment vehicle geared for retirement, and you get to decide the best investments that go inside the Roth IRA. Now we have that clear, here are some ways you could lose money in a Roth:

1. Market Fluctuations

Like any investment, the value of your Roth IRA can fluctuate due to changes in the stock market or other economic conditions. If you have invested in stocks, mutual funds, or other securities, the value of your Roth IRA may go up or down depending on the performance of these investments. It’s important to remember that investing always carries some level of risk, and you could potentially lose money in a Roth IRA if your investments don’t perform well.

2. Early Withdrawal Penalties

If you withdraw money from your Roth IRA before you reach age 59 1/2, you may have to pay a 10% early withdrawal penalty in addition to any taxes owed on the withdrawal. While there are some exceptions to this rule, such as for certain qualified education expenses or first-time home purchases, it’s important to understand the potential costs of taking money out of your Roth IRA before you are eligible to do so.

3. Over Contribute to a Roth IRA

There are limits on how much you can contribute to a Roth IRA each year. According to IRS.gov, for 2024, the contribution limit is $7,000 per year for those under age 50 and $8,000 per year for those age 50 and over. If you exceed these limits, you may have to pay a 6% excess contribution penalty on the excess amount.

4. Roth IRA Conversion Taxes

If you want to convert a traditional IRA or 401(k) to a Roth IRA, you may have to pay taxes on the amount you convert. If you are in a high tax bracket when you convert, you may end up paying a significant amount in taxes, which could reduce the overall value of your Roth IRA.

5. Required Minimum Distributions (RMDs)

Unlike traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) during the account holder’s lifetime. However, if you inherit a Roth IRA, you may be required to take RMDs from the account. If you don’t take the required amount, you may have to pay a 50% penalty on the amount you should have withdrawn but didn’t.

6. ACAT or Transfer Out Fees

When you open a retirement account with any broker, they will typically charge you an IRA custodial fee ($30-$75). If you decide to transfer your IRA out, they will ding you with the annual custodial fee and a transfer-out fee. Every firm charges a different amount. 

As an example, Edward Jones currently charges $95 to transfer an IRA from them. So you would have to pay $135 ($40 annual account fee + $95 termination of account fee).

What Type of Investments Can Go Into a Roth IRA?

You can invest your Roth IRA in a wide variety of assets, including:

1. Stocks: You can invest in individual stocks or mutual funds that hold a basket of stocks.
2. Bonds: You can invest in individual bonds or bond mutual funds that hold a diversified portfolio of bonds.
3. Exchange-Traded Funds (ETFs): ETFs are investment vehicles that hold a basket of assets, such as stocks or bonds, and trade like stocks on a stock exchange.
4. Certificates of Deposit (CDs): CDs are low-risk investments that pay a fixed interest rate over a set period of time.
5. Money Market Funds: Money market funds are mutual funds that invest in short-term, high-quality debt instruments, such as government securities and commercial paper.

It’s important to consider your investment goals and risk tolerance when deciding how to invest in your Roth IRA.

How Safe Is a Roth IRA?

In general, a Roth IRA can be a safe way to save for retirement because it provides tax-free income in retirement and allows you to withdraw your contributions at any time without penalty. However, like any investment, a Roth IRA carries some risk. The value of your Roth IRA may fluctuate due to changes in the financial markets, and there is always the possibility that you could lose money.

When choosing the right brokerage for your Roth IRA, consider the fee structure, account minimums, and investment options. Some brokerages have no account minimums and charge low fees, while others have high account minimums and charge higher fees. Additionally, some brokerages offer a wide variety of investment options, while others offer only a limited number of options.

Make sure they have SIPC coverage, and it’s always best to choose a financial advisor who is a fiduciary.

It’s important to diversify your investments and consider your risk tolerance when deciding how to invest in your Roth IRA. You may want to speak with a financial advisor or tax professional to determine the best strategy for you.

The Bottom Line – Roth IRAs and Losing Your Money

FAQ’s Can Roth IRAs Lose Money?

Cited Research Articles

1. IRS.gov – Retirement Topics Contribution Limits
2. SIPC.org – What SIPC Coverage Protects

The post Can You Lose Money in a Roth IRA? appeared first on Good Financial Cents®.

That said, there’s one major difference between the Roth IRA and the Roth 401(k). One of these plans is an employer-sponsored plan, and the other is a self-directed account that you can open on your own if you’re eligible.

With that in mind, it’s not surprising that the IRS allows certain specific benefits for each plan type. Read on to learn about the advantages of each of these accounts and other details to consider when you’re looking at the Roth IRA versus the Roth 401(k).

Roth IRA vs. Roth 401(k) – The Similarities

On the surface, the two Roth plan types seem to be identical. Here are some of the main similarities you should know about before you consider opening one or both of these accounts.

Both Provide Tax-Free Distributions in Retirement

The biggest distinguishing factor about these two Roth plans is the fact they create the opportunity to build up a tax-free income source in retirement. This benefit is available whether you have a Roth IRA or a Roth 401(k) plan.

In order to qualify for tax-free income in retirement, distributions that include earnings cannot be taken before you reach age 59 ½. In addition, you must be participating in a Roth plan for a minimum of five years at the time distributions are taken. But, as long as you meet those two criteria, the distributions you receive from the plan will be tax-free.

This makes Roth plans completely different from other tax-sheltered retirement plans, such as traditional IRAs and regular 401(k) plans. All other retirement plans are merely tax-deferred. That means that, while you get generous tax benefits during the accumulation phase of the plan with a 401(k), you will have to pay ordinary income tax when you begin taking distributions in retirement.

In this way, both Roth IRAs and Roth 401(k) plans provide excellent tax diversification strategies for retirement. This means either will allow you to have at least some tax-free income along with other income sources that are fully taxable.

Neither Offers Tax-Deductible Contributions

When you make a contribution to a Roth plan, whether it’s a Roth IRA or a Roth 401(k) account, there is no tax deduction upfront. This is unlike both traditional IRAs and 401(k) plans, where contributions are generally fully deductible in the year they’re made.

In fact, tax-deductibility of contributions is one of the major reasons why people participate in retirement plans. If you use a plan that does let you deduct your contributions upfront (i.e. a traditional 401k retirement plan), you get to lower your taxable income in the year you contribute.

You Can Withdraw Your Contributions From either Plan at Any Time – Tax-Free

Another unique feature of both Roth accounts is the fact you can withdraw your contributions at any time without having to pay either ordinary income tax or the 10% early withdrawal penalty on the distributions. This is in part because Roth IRA contributions are not tax-deductible at the time they are made.

But it’s also true because of IRS ordering rules for distributions that are unique to Roth plans. Those ordering rules enable you to take distributions of contributions ahead of accumulated investment earnings.

There is some difference in exactly how early distributions are handled among Roth IRAs and Roth 401(k)s.

Early distributions from Roth IRAs enable you to first withdraw your contributions – which were not tax-deductible – and then your accumulated investment earnings once all of the contributions have been withdrawn. This provides owners of Roth IRAs with the unique ability to access their money early, without incurring tax consequences.

With Roth 401(k)s, on the other hand, the contribution portion of your plan can also be withdrawn free of both ordinary income tax and early withdrawal penalties. But since they’re 401(k)s, they’re also subject to pro-rata distribution rules.

If you have a Roth 401(k) with $20,000 invested ($14,000 in contributions and $6,000 in investment earnings) then 30% ($6,000 divided by $20,000) of any early distribution that you take will be considered as investment income.

If you take a $10,000 early distribution, $3,000 of it, or 30%, will be considered investment income and subject to both income tax and the 10% early withdrawal penalty. The remaining $7,000, or 70%, will be considered a withdrawal of contributions, and therefore not subject to tax or penalty.

Both Offer Tax-Deferred Investment Returns

Despite the lack of contribution deductibility, both plans have one major feature in common with other retirement plans. With both the Roth IRA and the Roth 401(k), money contributed to the plans will accumulate investment income on a tax-deferred basis.

So, how can an account that is supposedly tax-free in retirement, be merely tax-deferred during the accumulation phase?

It comes down to early withdrawals. We’ve already discussed how you can withdraw your contributions early from either a Roth IRA or Roth 401(k) without creating a tax liability. But if your distributions also include investment earnings, the situation is different.

Accumulated Investment Earnings Are Taxable if Withdrawn Early

Whether you have a Roth IRA or a Roth 401(k), if you take distributions from either plan that includes investment earnings (which it will under the pro-rata rules for the Roth 401(k)), and you are either under age 59 ½ or have been participating in the Roth plan for less than five years), those earnings will create a tax liability.

Let’s say you have been taking early distributions from your Roth plan. You have already withdrawn the full amount of your contributions to the plan. You continue taking distributions, but you are now withdrawing funds that represent accumulated investment earnings.

Those withdrawals – the ones that are composed of accumulated investment earnings – will be subject not only to ordinary income tax but also the 10% early withdrawal penalty. In this way, early distributions from a Roth plan are handled the same way they are for other retirement plans, at least in regard to the withdrawal of investment earnings.

Distributions From Either Won’t Affect the Taxability of Your Social Security Benefits

This is another advantage that applies to both the Roth IRA and the Roth 401(k) plan.

Distributions from other retirement plans are added to your taxable income in retirement. Not only will those distributions be subject to income tax, but they will also affect your income in calculating how much of your Social Security income will be subject to income tax.

Under current law, Social Security income is subject to income tax using a two-tiered calculation. If your combined retirement income falls below one of these limits, then your Social Security benefits are not taxable. However, if you are single and your combined income exceeds $25,000, then 50% of your Social Security benefit will be taxable.

If you’re married filing jointly and your combined income exceeds $44,000, then 85% of your Social Security benefit will be taxable.

Note that the term “combined income” refers to income from all other sources – investment income like interest, dividends, and capital gains; other retirement income, like pensions and distributions from traditional IRAs and 401(k)s; and any earned income.

Amazingly, your Roth plan distributions don’t count toward that calculation! For Social Security purposes, it’s as if the distributions from your Roth plans don’t exist. Since they’re not taxable, they’re not included in “combined income” and will be excluded from the threshold calculations.

This is yet another way Roth plans provide for tax diversification in retirement.

Similarities Between Roth IRA and Roth 401(k)

That covers the similarities between Roth IRAs and Roth 401(k)s. But let’s move on to the differences,

Differences Between Roth IRA and Roth 401(k)

Most of the differences between the Roth IRA and Roth 401(k) have to do with the fact the Roth 401(k) is offered as an employer-sponsored plan. That by itself creates a lot of differences, including the following.

Contribution Amounts

The maximum you can contribute to a Roth IRA in 2023 is $7,000, or $8,000 if you’re age 50 or older. This is an increase from previous years.

That said, Roth 401(k) contributions are potentially more than three times higher!
The employee contribution limit for 2024 for a Roth 401(k) plan is $23,000 per year, or $30,500 if you are age 50 or older (up from $20,500 and $27,000 for 2022). If you participate in a 401(k) plan that also has a Roth 401(k) provision, you could actually contribute up to the maximum 401(k) contribution limit entirely to your Roth 401(k).

Now, that doesn’t mean you want to contribute the entire amount to the Roth portion. After all, the Roth 401(k), being a Roth plan, does not offer tax-deductible contributions. Depending on your age, $23,000 or $30,500 may be a lot of money to take out of your paycheck without getting a tax break. But, it still gives you a lot more room to allocate funds to a Roth plan than what you can with a Roth IRA account.

Employer Matching Contributions

As an employer-sponsored retirement plan, you can also get an employer-matching contribution in a Roth 401(k) plan. Since the Roth IRA is a self-directed account, the employer match does not exist.

Though not all employers offer either the Roth 401(k) or even an employer matching contribution, the ones that do may not make a distinction between a regular 401(k) and the Roth portion. In that situation, if the employer offers a 50% match on your contribution, that means there will be a 50% match on the part of your contribution that goes into your Roth 401(k).

There is one limitation on the employer match, however. Since a Roth 401(k) is a fully segregated account in your retirement plan, the employer cannot put matching contributions into that part of your plan. Instead, the employer match goes into your regular 401(k) plan.

That means that, even if you were to allocate 100% of your 401(k) contribution into the Roth portion, you would still have a regular 401(k) if the employer offers a match.

While it would be an advantage to have the employer match going into the Roth 401(k) as well, that would create a tax problem. Since the employer match is not taxable to you when made, it would be taxable when you begin taking distributions from the plan. For this reason, you’re better off having it in the regular 401(k) portion of your plan, where it will be tax-deferred.

Loan Provisions

Since a Roth 401(k) is part of an employer-sponsored plan, a loan provision may be available on it.

Not all employers offer loan provisions on their 401(k) plans. But if they do, the IRS permits you to borrow up to 50% of the vested balance of your account, up to a maximum of $50,000. Naturally, if you do take the loan against your plan, you will have to make monthly payments, including interest, until the loan is repaid.

Once again, since a Roth IRA is a self-directed plan, no loan provision is available.

Required Minimum Distributions (RMDs)

This is where a Roth IRA and a Roth 401(k) are completely different. IRS required minimum distribution (RMD) rules require that you begin taking mandatory distributions from your tax-sheltered retirement plan beginning at age 73. However, if the Secure Act 2.0 were to pass both houses of Congress and become law, the age you are required to begin taking RMDs could increase to 75 over the next decade,

Whatever age you wind up having to take RMDs, withdrawals are based on a percentage calculated based on your remaining life expectancy at the age that each distribution is made.

Either way, the difference between these two accounts is obvious here. Roth 401(k) plans are subject to RMD provisions, whereas Roth IRA accounts are not.

The benefit of not being required to take RMDs is you can allow your Roth IRA to grow for the rest of your life. This will enable you to leave a larger amount of money to your heirs upon your death.

**A Roth IRA is an excellent strategy to avoid outliving your money. Since RMDs are not required, the money in a Roth IRA can be available for the later years of retirement, when other plans may have been severely drawn down.

Income Limits

There are no income limits restricting your ability to make Roth 401(k) contributions. As long as you’re participating in the 401(k) plan, you’re able to make contributions to a Roth 401(k).

However, this is not true with a Roth IRA at all. If your income exceeds certain limits, you will not be able to make a contribution to this type of account directly.

For 2024, the Roth IRA income limits look like this:

• Married filing jointly, or qualifying widow(er) – allowed up to an income of $230,000, partial contributions allowed between $230,000 and $240,000, after which no contribution is allowed.

• Married filing separately – partial contribution on an income up to $10,000, after which no contribution is allowed.

• Single, head of household, or married filing separately AND you did not live with your spouse at any time during the year – allowed up to an income of $146,000, partial contributions allowed between $146,000 and $161,000, after which no contribution is allowed.

Trustee and Investment Selection

This is another area that usually favors Roth IRA plans. As a self-directed account, a Roth IRA can be held with the trustee of your choosing. That means you can decide on an investment platform for the account that meets your requirements for both fees and investment selection. 

You can choose a platform that charges low fees, as well as one that offers the widest variety of potential investments. You can even open your Roth IRA with one of the best online brokerage firms. 

But with a Roth 401(k), since it’s part of an employer-sponsored plan, you will likely have no choice in the matter. This is one of the biggest issues people have with employer-sponsored plans. The trustee selected by the employer may charge higher than normal fees.

They also commonly restrict your investment options. For example, while you might choose a trustee for a Roth IRA that has virtually unlimited investment options, the trustee for a Roth 401(k) may limit you to no more than half a dozen investment choices.

Differences Between Roth IRA and Roth 401(k)

Roth IRA vs Roth 401k: Which Will Work Better for You?

Fortunately, most people won’t have to make a choice between a Roth IRA and a Roth 401(k). That’s because current law allows you to have both. That is, you can have a 401(k) plan with a Roth 401(k) provision and still fund a Roth IRA. You can do that as long as your income does not exceed the limits required for making a Roth IRA contribution.

There’s also a maximum combined limit for contributions to all retirement plans. For 2024, it’s $69,000, or $76,500 if you’re 50 or older. The Roth 401(k), because it is part of a 401(k) plan in general, provides much higher contribution limits. This will enable you to save a very large amount of money.

As well, you always have the choice to allocate some of your 401(k) contributions into a regular 401(k). That means that the portion contributed to the traditional 401(k) will be tax-deductible.

Still, the big advantage to also having the Roth IRA is the fact you can access many more investment options. That means you can make the best of the investment selections offered within your 401(k) plan, but still expand your investing activities through your Roth IRA based on your goals. 

Finally, don’t forget that having a Roth IRA means you will already have an account in place if you leave your employer and need an account to transfer your Roth 401(k) into. In addition, you could also do a Roth IRA conversion of the balance that’s in your traditional 401(k) plan.

At the end of the day, all of this means that you should take advantage of both the Roth IRA and the Roth 401(k) plan if you have the option to do both.

The post Roth IRA vs. Roth 401(k) – Choose the Best Plan For You appeared first on Good Financial Cents®.