If you have access to a 401k or 403b account with an employer match, your first step in retirement savings should be to contribute to the point of the employer match in that account. Once you’ve done that, an Individual Retirement Account or IRA is the next place you’d turn to max out, then come back to your 401k/403b. There are two types of IRAs, a Roth IRA and a Traditional IRA. I often hear people say “I invested in an IRA.” But, an IRA is the account or what I refer to as the bucket. It is not an investment itself. You make investments inside the account, just like you would with a 401k, making contributions to stocks, bonds and other types of investments (I’ll share my perspective on investments in a future post).
Read further into this post, and you’ll get a glimpse of our plan for early retirement using these IRAs along with other accounts to provide an income for our retirement.
Below is a brief comparison of Traditional IRAs and Roth IRAs to help you weigh the options.
| Comparisons | Roth IRA | Traditional IRA |
|---|---|---|
| Tax Treatment for contributions | Contributions are made after tax, so subject to tax today vs. later. Gains inside the account grow free of tax. | Contributions are made before tax, so taxes are deferred or postponed until you withdraw later (subject to income limits) |
| Annual maximum contribution | $6,000 | $6,000 |
| Types of investments that can be made within the account | Index funds, stocks, bonds and more depending on what financial institution you choose. | Index funds, stocks, bonds and more depending on which financial institution you choose. |
| Income limits for participation | 2021 MAGI Single Less than $125k Full contribution 125-140k – Partial contribution $140K+ – No contribution allowed Married Less than $198k Full contribution $198k-208k – Partial contribution $208k+ – No contribution allowed If your income is too high for a Roth, you can do a backdoor Roth IRA! | 2021 MAGI No income limit for Traditional IRA contributions post-tax, but tax deductibility is subject to income as well as if you currently participate in an employer plan. Charts found here. |
| Can have alongside a 401k or 403b | Yes, subject to income limits | Yes, but deductibility subject to income limits |
| Withdrawal and taxes | Free of tax | Taxed at ordinary income tax rates |
| Required minimum distributions | No | Yes, starting at age 72 |
| Earliest withdrawal date | 59.5, but an withdraw contributions tax or fee-free at any time | 59.5 |
As you can see, there are definitely differences between the two accounts. But, there are clear reasons you might invest in each.
I’ll let you in on our plan to illustrate the use of these accounts
Over the years, we have maximized contributions to tax-deferred plans like 401ks and traditional IRAs, reducing our tax bill today while we’re in a higher tax bracket. Our income needs in retirement are much smaller, as we won’t have mortgage expenses, savings expenses and so forth. This will put us in a much lower tax bracket than we are today. When we retire early (at around 50-55), we will not have access to our IRAs until 59.5, so we need to have an income source to get us from 50-55ish to 59.5. Health care is also a big deal, because we won’t be Medicare eligible yet, right? Have no fear.
Our plan is to live off of the funds we have accumulated in both our savings and brokerage (non-retirement) accounts, as well as gig work here and there, until we reach the age to start accessing the retirement accounts. Capital gains on withdrawals from our non–retirement brokerage account are currently tax free up to around $80k per year for a married couple. Our lifestyle (even with travel, dining out, etc.) doesn’t really cost this much annually, because we understand exactly what our base expenses are, including our annual travel. If you think about it, during your working years, you are paying LOTS of expenses…savings in retirement accounts, mortgage, income taxes, etc. that shouldn’t be there during retirement. This is why it’s so important to pay down debts, pay off your mortgage and maximize savings during your working years. I hear financial experts telling people, “you need to have 80% of your pre-retirement income in retirement.” That is a very generic recommendation and one that I do not think is accurate for the vast majority of people. It is all about understanding your living expense needs, including the fun stuff like travel….it is NOT about your income.
With our brokerage (non-retirement) investment account, we will be able to withdraw up to $80k worth of gains per year (all that money made over the years in returns from saving and investing) and not pay income tax on that amount as a married couple. We can earn an income (or in our case convert IRAs) tax-free every year up to $25,100 as well because, as a married couple, we get a $25,100 standard deduction from taxes. So, during this same time, when we are no longer working 9-5, we will begin converting funds annually from our 401ks to Roth IRAs to lock them into an account that will not be subject to tax later. Much of our transfers we do will be done free of tax because we have very low annual expense needs (so, lower withdrawal needs) since we’ve paid off our home and have no debts to maintain. Once the money is in the Roth, it is locked in as tax-free. So, then when we go to withdraw as needed, it will be free of taxes (I will cover this in greater detail in a future post).
But, what about health care in retirement when you don’t yet have Medicare?
Over the years, we have been putting money into a Health Savings Account (HSA). Upon retirement, we will sign up for an ACA plan. And, because the subsidies offered are based on income, we will likely qualify for some level of subsidy. Savings/net worth do not equal income. Our plan is to sign up for a high-deductible plan so that we can continue funding our HSA annually (you need to be enrolled in a high-deductible plan to contribute to an HSA. You don’t in order to withdraw from it). That same HSA can be used to cover our needed medical expenses during this time, and the high-deductible plan is our “safety net” ensuring that medical costs don’t bankrupt us.
In closing
The choice between a Roth and traditional IRAs is largely a personal choice. Much of what I covered above is also subject to change based on laws, etc. The choice you make on these accounts is a question of whether you expect your tax rate to be higher now or later. Personally, because our expenses are low, we expect to have a lower tax rate in the future vs. what we have today. Therefore, we have prioritized our pre-tax accounts (note: we do have funds in a Roth too), but will do a lot of conversions from the 401k to Roth IRA after our W2 incomes are no longer.
Good luck!
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