These days, so many things that sound too good to be true are just that. It can actually become debilitating thinking about what is true and what isn’t. It’s often the fear of the unknown that prevents us from progressing and that’s not good.
It’s natural though. No one is an expert in every field. Few people have the knowledge necessary to allow them to know if something is too good to be true every time they’re faced with the choice.
There is one thing I know of that even though it sounds too good to be true, it does exist. While it’s becoming more popular, many people still don’t know how it can help them later in life. In fact, it’s so important that I’m finding more clients asking about it because they fear they might be missing out. And they’re right.
I’m talking about the concept of a tax free retirement account. Because many people still don’t know they exist or how to set one up, I wanted to highlight the main points about a tax free retirement account here. My goal is to give you the basics of how they work and help you feel more comfortable knowing they’re a viable option for your retirement. To start, I’ll define the tax free retirement account.
The easiest way to define the tax free retirement account is to acknowledge that you’ve already paid taxes on the income. Since you’ve paid taxes before making contributions, you can avoid taxes when it’s time to withdraw income from the account. The same is true for any interest earned, also known as growth. When you invest funds in vehicles like stocks and mutual funds, you can realize significant growth year after year.
It’s important to remember that growth is never guaranteed. It’s your responsibility, with the help of your advisor, to only invest in products that meet two qualifications:
While looking for returns is a great strategy, you’ll also want to only invest in products that are simple enough for you to understand.
Now back to growth. One of the most popular features of a tax free retirement account is their ability to shield any growth you gain from taxes. While this means you’re taxed on the income before it’s invested, any principal and interest that comes after the contribution is yours, tax free, so long as you meet certain rules.
While the tax free retirement account can be easily defined, I should also point out that they have a popular name; the Roth IRA. Even though 7 out of 10 companies offer the Roth IRA option in their 401k, only 18% of employees contributed after-tax dollars to their retirement. This fact alone could be the reason this investment account option is misunderstood.
While I want to focus on highlighting how great a tax free retirement account can be, I should also compare that type to the other popular retirement account type. Next, I’ll show how the tax-deferred and the tax free retirement accounts stack up with one another.
As mentioned, the other way to save for retirement is to use the tax-deferred option. These are the more well known options mentioned before that employees take advantage of at work. They’re known as IRAs (Individual Retirement Account) and you can find one either within a traditional 401k, or outside of your place of employment and with an investment company. A 401k is the term used for a feature within a qualified profit sharing plan which allows employees to save some of their wages aside into individual accounts.
While my goal is to simplify these concepts, comparing tax deferred and tax free retirement accounts can be confusing. The 401k is a way of contributing toward your retirement through your employer. Individual IRAs are a way of contributing outside of your employer. Often, within both methods of contributing are both regular and Roth options.
So after learning about the tax free retirement account option, why would anyone elect to pay taxes when the time comes? There are a few points that explain this.
To start, many people like the idea of contributing to retirement before paying taxes on that income. This lowers their taxable income now, with the understanding that they’ll have to pay the tax when they withdraw funds. Lowering your taxable income now sounds like a no brainer.
Another reason why people might not take the tax free route is because we want things to be simple. This sounds lazy, but there’s some truth here. Look at the data mentioned before. 70% of employers offer a tax free retirement account option but less than 1 out of 5 invested after tax dollars. Perhaps the traditional 401k is the first option employees have available and they won’t take the time to learn more about the Roth option. Maybe they’re too overwhelmed to learn enough about the tax free retirement account to make decisions they can be comfortable with, so they don’t bother.
What’s important to remember is that you have options when investing for your retirement. Whether you’re investing in a 401k through work or separately with an investment company, know that you can invest your dollars after you’ve already paid taxes on them or before.
Knowing this, is one way of investing better than the other? Should you only invest in the tax free retirement account and ignore the tax deferred option?
Next, let’s look at some scenarios to put in perspective if the tax free retirement account is a good fit for you.
As mentioned, investing dollars for retirement after you’ve already paid taxes on them is the way to go. This enables you to see the principal and the interest of your fund to grow tax free. So long as you meet a few conditions when you’re ready to withdraw the funds, you won’t have to worry about taxes.
But does that mean the tax free retirement account is the best option? Not necessarily.
One of the most important factors to consider is what your income tax rate will be in retirement compared to what it is while you’re working. Because congress loves making changes to the tax code, you’ll want to make a best guess on what your tax rate might be in the future compared to what it is now. It’s also important to remember to start where you are. See our article on the best tax-free retirement strategies, no matter your age. It’s never too late to start.
While considering how the income tax rate will affect what you can keep in retirement, remember the value of investing money in a tax free retirement account that you’ve already paid taxes on. There’s something special about not worrying about income taxes later in life.
Now that you know more about the tax free retirement account option and have decided you want one, let’s see how to go about opening one. Investing in a tax free retirement account might be the best financial decision you’ll ever make. In this spirit, see our article on the best tax free retirement account types when you’re ready to open one.
In the spirit of keeping investing simple, I’ll start with the obvious.
We’ve already talked about having access to a 401k at work, so let’s start there. If you work in one of the 70% of workplaces that offer the Roth option, ask your financial advisor how to open an account. Some of the main points to consider for qualifying are:
Opening the tax free retirement account at work, especially if you already contribute to a traditional 401k there, makes good sense. You can continue to work with the same financial advisor for advice. You can even manage both your traditional and Roth accounts through the same online portal. This makes managing your retirement convenient.
What if you’ve got more money to invest, but you’re maxed out on the Roth at work? You can always open an individual retirement account with a separate broker, a bank or a mutual fund company. While you’ll have accounts in various places, you’re confirming that you’re prepared to retire with dignity. You should also continue to be aware of income restrictions as you continue to invest. These guidelines will help you legally invest in your tax free retirement accounts.
The most important factor to retiring is taking ownership for your money and your decisions. But remember that you’re not alone. There are plenty of professionals ready to help you navigate new and unfamiliar territory. Let me know how I can help you when you’re ready to open a tax free retirement account.