By Steven J. Weil, Ph.D., EA, President, RMS Accounting

When it comes to retirement and Uncle Sam, the choice is often, “pay me now or pay me later.” But at some point, you will generally not only pay for the earnings you put away, but also for the income and growth generated by them.

The exception: a ROTH retirement account. ROTH accounts come in many flavors Including ROTH IRA, ROTH 401(k) and ROTH 403(b) plans. Because of the many choices, it’s important to do your homework and also to have a little bit of fortune teller built into your DNA.

If you believe that you will retire in a higher tax bracket than you are in today and that the value of having a little more to invest by delaying the tax on today’s earnings into the future, then one of the ROTH choices may be best for you. Putting money in a ROTH account means you won’t get a current tax deduction; but if you meet the holding requirements (at least 5 years) and the age requirement (being 59 ½), all distributions, including growth and income reinvested, will come to you and your beneficiaries tax free.  In addition, no tax will be due on any income or gains while in the account, and you get tax-free growth and income by only giving up a current tax deduction for funds contributed.

To be eligible to make a ROTH IRA contribution you must be income qualified, meaning that your ability to contribute phases out as income reaches certain thresholds. But, never fear, even those with too much income to qualify for a ROTH IRA can make a regular IRA contribution and then roll that contribution over to a ROTH IRA. Like regular IRAs, Roth IRA contributions are limited to no more than $5,500 of earned income per taxpayer and $6,500 for those aged 50 or older.

For the self-employed, controlling shareholder of a corporation or managing member of an LLC, there are many other retirement plans to choose from.  Just understand that some require high wages to maximize benefits and others require less in wages but also restrict how much can be deferred.  There are many types of plans for the self-employed as well as those  who own and operate corporations, including SEP IRA, SIMPLE IRA, DEFINED-BENEFIT, DEFINED-CONTRIBUTION and 401(k).  All must include employees and have contribution and funding rules that must be carefully followed.

Just as with a regular IRA, deferral means that while you don’t pay tax on income and growth while it is in the plan, you will pay tax on them when you take funds out of the plan.  If your contributions are tax deductible or tax deferred, you will also reduce your current tax bill by deferring tax on your contributions, but you will have to pay tax on those funds as well when you  take distributions.

For example, as you can see by the chart on Exhibit 1, if the same $5,500 were invested each year in a tax-deferred account and it grew at a rate of 8%, the balance in the tax-deferred account at the end of 20 years would be $271,826.  The same investment in a taxable account at a tax rate of 28% with the tax being paid from the account on the 8% would have an account balance of only $208,535 at the end of 20 years. The higher the return on your investments, the higher the tax rate will be; and the longer the term, the greater the benefit from tax deferral. But it’s important to keep in mind what the tax rate will be when you retire and how much in taxes you will be paying on your distributions.

Chart of Taxable vs Tax Deffered

As you can see, this is a complex topic requiring important choices and some premonition as to what the future holds.  Will your income go up, placing you in a higher tax bracket? Will the government raise taxes, putting everyone on in a higher bracket? Will you retire making more or less than you are today? What kind of return do you expect to see on your investments?

All of these questions are important when choosing a plan that best serves your needs. But one thing is certain: the longer you wait to start planning for retirement, the harder it will be to accumulate the funds you need to retire. While how much you put away and what kind of plan you choose are both important, the most important thing is how soon you start.