In my last post on the progressive US tax system, I used the example of Jane who works as an employee for a company. Jane makes a salary of $65,000 a year. We determined that Jane was responsible for paying Social Security and Medicare tax of 7.65%, federal tax as per the progressive schedule and Georgia state tax of 5.375%. After paying her tax on the $65,000 in income she was left with $49,921 to pay her bills and live.
Jane wants to start to build a retirement account for the future. Jane may have several options for saving. These include a 401K if her company provides one and if not a Traditional IRA or a Roth IRA. There are other company provided retirement accounts but for sake of simplicity we will use the most popular, the 401K. These accounts are called qualified retirement accounts which means that it is an account recognized by the IRS as an account where investment income accumulates tax deferred, emphasis on deferred not tax free. Below is a brief explanation of the three qualified accounts mentioned above.
• A 401K is a company provided qualified retirement account that allows all fulltime employees to contribute to it out of their salary using tax deductible contributions. Jane must still pay the Social Security and Medicare tax of 7.65% on the monies contributed. The current contribution limit is $19,500 with a catch-up contribution by those 50 and over of $6,500. The money in the account and the annual investment income accumulate tax deferred until it is withdrawn in retirement. Currently you must be 59.5 years of age or older to take the money out without a penalty. When it is withdrawn it is taxable as taxable income in the year withdrawn.
• Traditional IRA- With a Traditional IRA, you contribute pre- or after-tax dollars, your money grows tax-deferred, and withdrawals are taxed as current income after age 59.5. If Jane’s company doesn’t provide her with a retirement account to contribute to like a 401K, she can contribute to a Traditional IRA on her own. The maximum contribution for Jane is $6,000 a year or $7,000 a year when she is over 50 years of age. These contributions like a 401K are tax deductible.
• Roth IRA- With a Roth IRA, you contribute after-tax dollars, your money grows tax-free, and you can generally make tax- and penalty-free withdrawals after age 59.5. The contribution limits are the same as a Traditional IRA, $6,000 or $7,000 over 50, annually. If Jane is in a tax bracket equal to or lower than the tax bracket that she will be in in retirement, she will want to pay the tax in the current year and contribute after-tax dollars to a Roth IRA instead of a Traditional IRA. The contribution and earnings on this money are never taxable. Jane is in the 22% federal tax rate bracket, which is historically a low tax bracket therefore, it might be prudent for her to contribute to a Roth IRA instead of a Traditional IRA. If Jane contributes $6,000 a year from age 25- age 50 and invest this money in a balanced bond and stock portfolio earning 6% annually, she will have $348,228 in 25 years, none of which will ever be taxed.
Jane should use one of these three options to save for the future. Social Security with a maximum monthly payout of $3,113 and the average benefit being $1,543, is completely inadequate to live a full life in retirement.
Before choosing which type of qualified account to use to save for retirement, you should consult with a Certified Financial Plannerfor their expertise. There are many limits and conditions on each one of these choices.