Personal Finance – 103 Retirement

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Contribute up to your company’s match rate into your 401(k). 

If you are not contributing up to the match rate you are missing out on free money.

Roth-IRA vs Traditional-IRA

I’ll start by saying I understand the differences but I don’t understand how to decide which is best. I have decided to setup both. I have a traditional 401(k) through my work. I also setup a separate Roth-IRA through Charles Schwab. Through the Charles Schwab Roth-IRA I have direct control of the funds. I can invest in the stocks, ETFs, etc that I want. I use this account to learn and try stock investing. The traditional-IRA is invested in an S&P500 fund. I contribute up to the match rate to the traditional-IRA.

In gathering information I have asked a couple different people about when to use a Traditional vs Roth IRA. Here is there feedback.

Feedback 1: 

Generally a Roth is better for younger people (I’m 36) because the money grows tax deferred.  You do have to pay taxes on it up front but all of the growth is tax free when distributed if taken after retirement age.
However, in your case I might recommend at least one of you (my wife or I) do a traditional 401k.  And here’s why.  You are looking at getting into real estate.  Real estate losses are disallowed if you have an Adjusted Gross Income of a certain dollar amount or more. Last year you were close to the threshold.  So you would probably need to do the traditional 401k in order to use your real estate losses.
If you didn’t need to take the losses right away, you could potentially do the Roth for a couple of years and then switch to the traditional to bring your income down.  Disallowed real estate losses carry forward so if you could make a significant contribution to the traditional 401k, you could potentially plan to take all of the real estate losses in a particular year.  We would probably want to make sure you contribute enough to get down below the threshold. This is a bit of a gamble because if your income goes up substantially, you may not recover the real estate losses anytime soon. On the other hand tax deferred growth could be worth the potential disallowance of real estate losses.  Depends on market growth.

Feedback 2: 

The big advantage of a Roth IRA over a taxable brokerage account is the tax-free growth of your investment. You do not have to pay capital gains tax when you sell the assets in a Roth IRA, nor do you incur ordinary income tax on any interest or dividends you earn. Contributions can be withdrawn at any time without penalty or tax. However, the disadvantage is that any earnings withdrawn before age 59 1⁄2 incur a 10% penalty plus income taxes. After age 59 1⁄2 you can withdraw earnings tax-free and penalty-free. There is also a yearly contribution limit ($6,000 for 2020) and you won’t be eligible for a Roth IRA if you earn too much. The amount you can contribute to a Roth IRA begins to shrink at certain thresholds for modified adjusted gross income, and keeps shrinking as income rises, until your ability to contribute is eliminated completely (reduced at income levels between $196,000 and $206,000 and completely eliminated at incomes over $206,000 for married couples filing taxes jointly in 2020) A Roth IRA can be opened at most online brokers (Schwab, Fidelity, etc) and you can choose your own investments. It might be something to consider in addition to your taxable investment account.

Feedback 3: 

To find effective tax rate divide the number on line 16 on your IRS Form 1040 by the number on line 11b. (16/11b) If your rate is 0-10% I would suggest Roth contributions. If the amount is >10% I would do Pre-tax. Know that any employer contribution (match) will be pre-tax regardless of your deferral type. If you just like the idea of paying taxes now to avoid future tax liability the do Roth, but most people are in a significantly lower tax bracket in retirement than when working.

This video is a pretty good explanation. He covers the advantages/disadvantages of both.

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