There are several different strategies to help you reach your retirement goals, and it is a good idea to use them in concert with each other to tap into as many different strategies as possible and use all the different available resources as tools. In this post, we will discuss and compare traditional savings and a Roth IRA account.

The End Goal of Retirement Savings

The goal of retirement savings is to put away a consistent amount of money and allow it to grow over time. The government provides different incentives, programs, and tools to help people accomplish as much as they can and get as much out of their savings as possible. One important resource is Social Security benefits. Upon reaching an old enough age, everyone is entitled to a monthly amount of cash for the rest of their life.

The amount depends on how long you worked, how much you earned, and at what age you start to collect benefits. For most people, Social Security will make up a major source of income in retirement, but it will not be enough to fully pay for all bills, expenses, and spending. That means other forms of savings need to make up the gap.

Traditional Savings

A traditional savings account is just an account at a bank where you store money. You receive an interest rate that causes your savings to grow on their own, and you can also contribute to the money out of your earnings. It is possible to set up regular deposits that will happen automatically on a certain day of the month, which can help take the pressure off remembering to do this on your own and make it a smoother process.

The pros of a traditional savings account include the fact that the money is insured by the FDIC up to $250,000 per account, so you don’t have to worry about losing everything. You also have the simplicity and convenience of the money just staying at your bank. The major downside of the traditional savings account is that they have very low-interest rates.

While there have been times in history when a savings account might have had a high yield, most of the time, including now, it is hard to find an account that can even keep up with inflation. So while they are safe, a savings account has a lot of trouble providing a significant amount of growth. It is that growth that makes retirement savings add up to something big by retirement age, so this is a very important downside.

The Roth IRA

A Roth IRA is a special kind of investment account that is defined by the government. It has several important properties. First of all, as an investment account, it works differently from a savings account. In an IRA, you add money to the account and use that money to buy stocks, bonds, and other investments.

Usually, you don’t have to do all of this manually– you will pick one or more choices for investments at the beginning, and the money that you add will automatically go towards buying more units of those investments. Most people pick mutual funds or other types of investment that include a broad and diversified set of assets in their portfolio. So far, this is similar to a brokerage account.

Understanding the Tax Advantage

What really sets the Roth IRA account apart is the tax advantage. Normally, investment savings are taxed twice. First, the money is taxed when you earn it as income– you pay federal income taxes on it before investing it. Then, the money is taxed again once you sell off your investments and withdraw the money to use for retirement spending. In a Roth IRA, the distributions that you take at the end are not taxed, so you do not have to worry about paying out a chunk of your savings into a tax bill. This is a big advantage for Roth IRAs.

With the right investments, a Roth IRA will have a much better rate of return than a traditional savings account. However, these investments involve risk, and it is possible to lose money instead of gaining it. Over time, compound interest will play to your favor and allow money to grow. You can use a compound interest calculator to forecast where your money will wind up.

Open Your Roth IRA

Everyone has access to opening their own Roth IRA, although there are annual limits to how much you can contribute. It is entirely possible to use both a savings account and a Roth IRA at the same time. For example, you could save money in the Roth until you hit the max for the year, then put the rest into a traditional savings account until the limit resets the next year. Or you could focus your retirement savings in the Roth IRA and use the traditional savings account for something else, like an emergency fund or savings for a down payment.

There is no perfect strategy for saving for retirement, and different people will make different decisions about which tools to use and how many of them to use. What is important is starting as early as possible and making sure that you stay consistent with your savings. Compound interest is very powerful, but it takes a long time to fully take effect. Without years and years of saving and investing, there will not be enough accumulated interest to make the money really grow, and that is what it takes to save enough to make for a retirement that meets all of your needs and maintains a balance long enough to keep your budget in good health.

What Secure 2.0 Means

The SECURE Act was passed as a part of the year-end appropriations act in 2021. The bill included provisions to prevent Americans from outliving their retirement savings. Longer lifespans mean that what was once adequate for retirement will not run out before the person reaches the end of their life. This leaves many older Americans in a desperate situation as they age.

Some of the main achievements of the original SECURE act include:

• Easier for small businesses to set up “safe harbor” retirement plans.
• Part-time workers eligible to participate in an employee-sponsored retirement plan.
• Pushed back the age for required minimum distributions to 72.
• Non-spouses who inherit IRAs must empty the account within 10 years.
• 401(k) plans offer annuities.

Secure 2.0 expands the provisions of the SECURE Act. This Act expands auto-enrollment and auto-escalation of personal contributions to employer-sponsored retirement plans. What this means is that new employees would automatically be required to enroll in 401(k) and 403(b) plans at a rate of at least 3 percent. This amount would automatically rise by 1 percent each year until the employee contribution reaches 10 percent.

The required minimum distribution would also go up from 72 to age 75 in Secure 2.0. This latest version of the bill does not affect workers who do not have access to an employee-sponsored retirement plan, but it will help boost the savings of those who do.

Limits on Conversions

One of the effects of Secure 2.0 is that it eliminates “back-door” conversions. This type of conversion occurs when someone converts a traditional IRA into a Roth. This was once a favorite tax shelter of the wealthy. This Act bans these types of conversions for those that meet certain income levels.

Another effect of the Act is that it would bar IRA contributions for those who make over $10 million and who also have an annual income of over $400,000. Accounts exceeding $20 million would be required to make withdrawals if the new Act passes. This class of account holders would also be barred from converting a traditional IRA into a Roth.

What Does This Mean for the Average Retirement Account?

For those who do not have accounts over $10 million and income of over $400,000, Secure 2.0 allows many to boost the amount of Roth money in the account. In some cases, it even mandates contributions to Roth accounts. However, this can have major tax consequences and could create traps for some taxpayers.

With a traditional IRA, the account is funded with pre-tax money, but you will have to pay taxes when you begin to take distributions. This means that you will keep less of your withdrawals at a time when you need them the most.

With a Roth IRA, the contribution is taken out after you have already paid taxes on the entire income amount. You will not have to pay taxes when you begin making withdrawals. This means more money to pay expenses in your retirement years.

One of the key concerns is that some employers feel that their employees will not be able to comprehend the tax advantages of a Roth IRA, so they only offer traditional IRAs. One of the arguments in favor of this approach is that this reduces the current income and allows employees to take advantage of other tax breaks now.

The problem with this thinking is that this one-size-fits-all approach does not work for all taxpayers. In some cases, taxpayers would be better off putting the money into a Roth IRA and taking advantage of those tax savings. When you consider the compounding effect of the money in the retirement account, saving money on taxes now is a one-time event. It only amounts to greater security if the employee then puts it into a Roth IRA.

For instance, a tax savings of $100 puts more money into the pocket of the employee that they can use for expenses, entertainment, or any other reason. If the employee were able to invest that same $100 in a Roth IRA with a historical rate of return of 7-10 percent, it would be worth $200.97 in ten years. This is based on only just the one-time deposit amount and no other contributions. The same $100 doubles in a 10-year time period without any additional action. You can see how this works using this compound interest calculator.

This is the reasoning behind the Secure 2.0 Act. The Act requires enrollment in a 401(k), 403(b), or SIMPLE IRA plan. Money saved on taxes during a person’s working years is more likely to be spent on unnecessary expenses rather than being invested and turned into savings for when the person does not have the additional income to rely upon.

Increases Available Plans and Catch-Up Amounts

Another effect of the Secure 2.0 Act is that it provides incentives for small employers to offer plans. When small employers start a retirement plan, they can receive a start-up credit of 100 percent for the first three years. This is a big saving for employers who choose to offer plans for their employees.

Currently, if you are behind in your retirement savings, the Secure 2.0 Act will allow you to increase the catch-up amount from $6,500 to $10,000 a year. To qualify for this catch-up amount, you must be between 62 and 64 years old.

For the average person who does not have the amount needed to be on track for retirement, the Secure 2.0 Act provides an opportunity to catch up and build the long-term savings you need. The most important thing, whether you are approaching retirement age or just beginning your retirement planning journey, is to take advantage of compounding to help you reach your retirement goals.

There are lots of ways to save for retirement, and one of the most important is the individual retirement account, or IRA. The IRA is a type of account that allows for a reduction in the taxes that you would normally have to pay when it comes to investing. On this page, you can learn more about the characteristics of IRAs, the types of taxes that are involved, and what kind of benefits an IRA can involve.

Taxes on Stocks, Bonds, and Other Assets

When most people invest in stocks, bonds, or other assets, they have to deal with two types of taxes. First of all, they need to pay taxes on their income before they can invest. That is the set of federal, state, and local taxes that get taken out of each paycheck. The money that you actually get in your bank account or check is often called “after-tax dollars” because it is what is left over after taxes.

When you invest after-tax money in something and that asset grows in value, eventually you will want to sell the asset so that you can use the money that you have grown for expenses or purchases. Unfortunately, when you sell the assets, then you have to pay another set of taxes– capital gains taxes. This is why investments are referred to as “double-taxed”– by the time you get money back from your investment, you have had to pay two sets of taxes, which seriously cuts into the value of the investment.

How Taxes for Traditional IRAs are Different

IRAs are special accounts that the federal government has authorized to help reduce the tax burden for people trying to save for retirement. There are two types of IRA: traditional and Roth. Each one allows you to avoid one of the two types of taxes.

A traditional IRA allows for tax-deferred growth. That means you can contribute money to a traditional IRA using “pre-tax dollars”– the money is not subject to income tax. This is resolved by giving you a tax credit that you can apply to your taxes at the end of the year. The money in the account can be invested in stocks, bonds, or anything else. Usually, the bank or financial services company that holds your IRA also provides a set of diversified funds that you can invest in.

You will still need to pay taxes on the accumulated assets in a traditional IRA when it comes time to sell them for cash. For most people, that will be during retirement: there are special tax penalties for withdrawing too early from an IRA account.

Roth IRA Provides another Tax Option

The other type of IRA, the Roth IRA, works the opposite way. You use post-tax dollars to contribute to a Roth, but then the money will grow tax-free, and there is no obligation to pay taxes on the investments once it is time to withdraw from the account. Like the traditional IRA, the Roth IRA should only be used for retirement– you need to pay a big tax penalty if you take money out too early.

Whether to use a traditional or a Roth IRA is somewhat subjective. Often, people base the decision on whether they also have a retirement account through their employer, like a 401k or 403b. If you have a traditional 401k, you might want a Roth IRA, and vice versa.

Calculate and Plan Your Retirement Investments

If you want to find out how your investments are doing, then one good approach is to use a compound interest calculator. For example, if you enter in how much you have saved so far as the principle, then add in your expected rate of return as the interest rate along with how much you plan to contribute on a regular basis, you will get an estimate of how much the investments will be worth in the future.

This is a good way for you to start planning out your retirement. The more information you have, the easier it is to motivate yourself to set up your accounts and start to make contributions. IRAs are important tools on the road to retirement because of their tax benefits, but that can only happen when you are adding more money to the account and letting it grow.

Now that you know more about the different retirement accounts, you can determine the interest amount and the final amount of money you’ll have with each IRA. With more knowledge, you can make a better decision regarding your money and retirement plans.

First, research the topic, so you know the mechanics of creating a custodial IRA. Then, take the chance to explain to your children nine and older how interest works. Finally, use a compounding calculator online to demonstrate the concept to them and develop a few savings scenarios based on differing contribution amounts.

Finally, work through an example calculation on your own (see below) to reinforce the basic math behind long-term savings. Opening an IRA in a child’s name is an excellent way to teach children and to begin putting money aside for their future.

Exploring the Topic of Child IRAs

Find out about the general rules for custodial IRAs. For example, it’s worth noting that the Roth IRA is the better choice in nearly every situation, compared to a traditional version, for children. Other important facts to know about IRAs for kids include the following:

• The limit for contributions is currently $6,000 per year
• Neither you, your child, nor anyone else can contribute amounts to the IRA that exceed the child’s earned income for the year of the contribution.
• It’s best to document the child’s earned income by evidence like a W-2 or a 1099 form.
• You cannot include allowances or gifts as part of the definition of “earned income,” even if you pay your child for doing household chores.

However, there are some exceptions to this rule if you hire your child to do small jobs in a family business or to do contracted work directly for you, and you pay the going rate for the work.

• You must be the custodian of the account until the child reaches the age of 18, 19, or 21, depending on the state laws where you live. After that, the child takes complete control of the account.
• There’s usually no sense in opening a custodial IRA for a child under the age of 10.
• If your child has earned income, and you have opened a custodial IRA for them, anyone can put money into the account up to the child’s earned income, or $6,000, whichever is the lower amount.

That means if your daughter earns $5,500 from babysitting, you can choose to let her keep the money. Then, you could put $5,500 into the IRA for her. Many parents use this system to encourage their kids to earn money of their own and learn about the value of retirement savings.

The Incredible Power of Compounding

One of the many benefits of opening a custodial IRA for a child is that it gives you the chance to teach them how to earn money and save it responsibly. Plus, the account has the opportunity to grow for many years, often more than 50, before the child reaches retirement age.

The impact of a 50-year timeline on an interest-earning account is significant. Consider an example using a compound interest calculator. For our hypothetical but very realistic example, we’ll assume that you open a custodial IRA for your daughter, Jill, when she is 10 years old and that she earns $5,000 babysitting and mowing neighborhood lawns every year until she goes to college after turning 19.

Jill’s Contributions From College Until Age 65

Each summer during college, Jill earns enough money from part-time jobs that she is able to continue the annual IRA contributions in the same amount, $5,000. Note that she could contribute $6,000 per year if she wanted to but chooses to keep the $5,000 amount.

After college, Jill works until age 65 at a full-time job, adding $5,000 each year to her Roth IRA. Using the calculator, we figure that she has made 56 annual contributions, from age 10 until age 65, to the account and that the account had an average yearly interest rate of five percent.

Using the Calculator

Input the data above into the compound interest calculator and see how much Jill has in her Roth IRA at age 60. Assume zero opening balance, annual interest of 5 percent, annual contributions, and 56 annual payments.

Jill has $1,436,741 in the account at retirement, of which $1,156,741 is interest on the cash contributions of $280,000.

You can use one or both of these to invest your savings, gain compound interest, and avoid some of the taxes that would be due on a regular investment. This can help your money increase more quickly and take advantage of compound interest. The different ways that traditional and Roth accounts manage taxes can be tricky to understand, but it makes a big difference in terms of savings rates.

Traditional Accounts

The traditional account is something that is available to everyone. If you work for a company, then you might have access to a 401(k) plan. If it is a nonprofit like a school, it might be a 403(b) plan instead, but the idea is the same. When you contribute a percentage of your salary to this account for savings, your employer matches some of that and puts more money into the account.

Then you can choose how to invest that money so that it grows. You can use a retirement account even if you don’t have one provided by your employer– an individual retirement account, or IRA, is a similar account that anyone can open and start contributing towards.

Understanding Taxes

Under normal circumstances, money that you invest from your salary income or any other source of income will be taxed twice before you can eventually spend it:

1. It is taxed as income when you earn it. For most people, this will be via regular payroll and employment taxes.
2. You take that post-tax money and invest it in some assets, like stocks and bonds. After you save the money and it grows with compound interest, you sell the investment, and then the money is taxed again with capital gains tax.

In a traditional account, you do not need to pay the first set of taxes, the income taxes. Any money that you contribute to such an account is tax-deductible. You will eventually need to pay the second set of taxes once you finally start to withdraw the funds from the account, but that happens decades into the future. The fact that you can avoid the first set of taxes means there is more money to get compound interest working in your favor on a more considerable starting value, which makes a massive difference over time.

Roth Accounts

A Roth account works the same way, but it allows you to avoid the second set of taxes, the taxes on the gains, once you withdraw the final amount. The advantage of the Roth approach is that you don’t need to consider paying taxes on your retirement income, and you can treat the whole amount as available to use. You will contribute money to a Roth account just like a traditional account, but you do not get to deduct those contributions from your taxes. With most employers, the default retirement account is a traditional 401(k) or equivalent, so you may need to open an IRA and make it a Roth if you want to take advantage of this style.

Mix and Match Retirement Savings

You do not need to commit to one of these account types or the other– you are free to mix and match them. Please take note that they both have annual limits about how much you can add to each one. By putting some of your retirement savings into each type of account, you can hedge your bets about taxation.

The traditional account is better if you believe that your current tax rate is higher than when you will withdraw the money, and the Roth is better if you believe that your future tax rate will be higher than now. This is hard to predict for most people, so putting some money into each kind balances this out and allows for a unified approach.

If you want to understand how your savings will grow, the best approach is to use one of our compound interest calculators. The calculator is very easy to use. Start out by entering an initial amount, which is the first contribution to your account. Then enter a 12 month period and how much you expect it to grow each year, how long you plan to leave it in the account, and the frequency and amount of contributions. Finally, it’s a good idea to make some different scenarios for the growth rate so you know what to expect under different circumstances for your investment.

Roth Conversions Explained

The main difference between a Roth IRA and a traditional IRA is when you pay taxes on the money. With a Roth IRA, your contributions are taxed before they are applied to the account. This means that when you are ready to withdraw the money during your retirement, you will not have to pay any taxes at that time. With a traditional IRA, your contribution is made with before-tax dollars, and you will have to pay taxes when you begin receiving distributions. This means you will see a larger paycheck during your contributing years, but you will pay when you withdraw the money. 

Roth IRAs have several other advantages, such as they do not require minimum distributions. You can also pass on Roth IRA assets to your heirs tax-free. In addition, some accounts allow you to convert your traditional retirement account to a Roth IRA. Some people do this to avoid the required distributions of traditional IRAs and allow their money to continue growing tax-free. 

The catch is that because you have not already paid taxes on the money in the Traditional IRA, you might have to pay the taxes owed at the time when you do the conversion. To make the decision, you have to calculate how much you would the gain in interest if you left the money in the account.

Input the relevant principal, interest rates, and how much longer you will be contributing until your retirement. The calculator will provide your expected retirement savings at the end of the time period. Compare that amount versus any taxes or fees you would pay to make the conversion. At least, this is how it works if you are the average person with an average income level. This might not be the case if you happen to be a billionaire. 

What Are the Proposed Changes?

Currently, many accounts are available for conversion to a Roth IRA, but they have to follow specific rules. The proposed changes would eliminate back-door conversions for those with giant tax-sheltered IRAs. The Roth IRA was developed to help middle-class Americans save more for their retirement. In addition, it was meant to ease the tax burden on those with average incomes so that they would not have additional taxes at a time when their earning potential is reduced.

This new proposal came about because it was found that billionaires, such as Peter Thiel, were using their Roth IRAs as a tax shelter for millions of dollars of capital gains from investments. A third-party investigation found that Thiel had approximately $5 billion in his Roth IRA.

Thiel, and others, were able to enjoy the tax-free accumulation of wealth using a loophole in the Roth IRA law. How it worked is that Thiel started his Roth IRA account with shares of his new startup company, Paypal. At the time when he opened the account, the shares were valued at under $2,000 total. After that, the company grew, and as it did, the value of the shares in his Roth IRA account grew to the $5 billion mark. 

The catch is that all of this money grew and was treated as if taxes had already been paid on it, as it would be if it were a regular contribution from a paycheck. For the average American, most had already paid taxes that were deducted from their paycheck before the contribution was taken out and put into their Roth IRA account.

The money in Thiel’s account grew without passing through the system that applies to most Americans. Because it was not from the sale of a stock, he never had to report it on his taxes as a capital gain and pay taxes on it. It was never taxed as income. He can then withdraw the money tax-free at age 59 ½, never having paid any taxes on the money at all. The proposed law would eliminate this loophole for the ultra-wealthy. 

Who Would It Affect?

Changes would only affect those with retirement accounts that exceed $10 million and those with an annual income of over $400,000. Those with balances in their retirement account of over $20 million could be forced to make withdrawals. Roth conversions would not be allowed for these retirement accounts.

For most, these new changes will not have an effect because it only affects those whose retirement accounts exceed these thresholds. The major impact that it will have is that it cuts out a tax loophole for wealthier Americans, but most will not see a difference in their accounts.

When Not to Convert to a Roth IRA

In some cases, converting to a Roth can make sense, but for others, it may be best to stick with your traditional IRA. One thing that can make a difference is a little-known IRS rule that for distributions to be tax-free, they can only be made after a period of time in which you pay taxes on them. You must have the five-year waiting period completed by the time you reach age 59 ½. If the five-year waiting period has not passed, you will have to pay taxes on your distributions just as if they had stayed in a traditional IRA.

Taxes Might Be Due

Another thing that might make converting to a Roth IRA inadvisable is that it can trigger taxes. In some cases, the IRS will make you pay a lump sum or catch-up taxes to enjoy tax-free distributions. If you believe that your tax bracket will drop after retirement, it might not make sense to take action that will trigger additional taxes when your income is lower.

If you have $300,000 in your IRA, you might have to give up $75,000 of it if you convert it to a Roth. You would not only lose the initial amount of the balance, but you would also lose any earnings in the future. There are some ways to offset the taxes, such as making charitable contributions, but you still will not have the compounded interest from the money. Keep in mind that when you convert to a Roth IRA, you will pay taxes at your current income and not your future income rate after retirement, which means you might pay significantly more.

When Does Conversion Make Sense?

There are times when a Roth conversion makes sense. One of them is if you do not want to start receiving the required distributions that are required by traditional IRAs beginning at age 70 ½ if you reached this age by 2020, or 72 otherwise. If you convert to a Roth IRA, your money can continue to grow tax-free without having to begin withdrawing it. Another scenario where you might consider a Roth conversion is if you plan to pass on your retirement account to your heirs, and you want them to enjoy the tax-free growth.

Another thing to consider in making the conversion is whether you think taxes will increase in response to increased federal debt. If you think you will be paying higher income taxes in the future, you have to consider your overall projected financial picture after retirement. This might be a good move for some, even though they might face some tax consequences when they make the conversion.

If you are above a certain income level, a conversion is not allowed. For instance, if you are single and your income is between $124,000 to $140,000, you might not be able to convert to a Roth IRA. For married couples, the range is from $198,000 to $208,000.

Calculating Your Retirement Savings

The first thing you need to do is to do your research and find out if a conversion is allowed for you. The second thing you need to do is to calculate how much your money would grow if you kept it where it is now against the tax burden and any penalties you would have when you made the conversion.

To calculate your retirement savings, online interest calculators are great tools. Start by entering your current savings as the principal. Then enter the interest rate, compound frequency, and how long you plan to keep saving. Enter your contributions and how often you make contributions under payment and payment frequency. This will give you a good idea of how much retirement savings you can expect to have.

It might be best to consult a retirement consultant before you make a move to make sure there are no rules you were unaware of that could affect whether it is worth it.

There are several times when converting to a Roth IRA might not have any advantages. One of them is if you are five years from retirement or less. Converting to a Roth can trigger additional taxes, and this might offset any gains. Your age and what you plan to do with the money in the account are the most significant determining factors on which decision is right for you. The most important thing to remember is to do your research and consider the tax and distribution consequences to your future.