Roth IRA-After Tax Today For Tax Free Later
Ira Roth in 1998 introduced the concept of Roth IRA. A Roth IRA is an individual retirement account that allows the accumulator to withdrawn the deposits invested without tax liabilities. Unlike Traditional IRAs or 401Ks which allow tax deductible contributions and taxed withdrawals, these retirement accounts are available for any individual whose income falls below certain stipulated levels.
A benefit not many realize is offering the opportunity to save on taxes while saving for your retirement. Its earnings are taxed at the withdrawal level, which is likely much less than the amount you deposited into the account. The other advantage of a Roth IRA is that if at the time of withdrawal you are over the age of 59, the earnings earned in the account can be withdrawn tax free.
The biggest benefit is that to contribute to a Roth IRA you need not have sufficient income and neither do you need to justify the contribution. To put it in a nutshell, income levels play no role in deciding on whether to contribute or not to contribute.
The only requirement is that when you do the conversion you are either over the age of 59 or under the age of 70 and a half. The last requirement is that you have earned income equivalent to the contribution.
Thrift Savings Plans
A thrift savings plan (also known as a TSP) is a retirement savings and investment plan sponsored by the US government. Similar to the 401k, the TSP plan assists in saving for retirement by deploying contributions into a portfolio of low-cost mutual funds, which are owned by the US government.
Investing in the TSP is a good way to save for retirement as contributions are very flexible, and withdrawals from the fund are penalty-free at any time.
However, there are a few drawbacks. The government adds an annual contribution of 1% of military or Federal service pay annually towards the TSP account if the person contributes an amount less than 4% of their annual pay. This matching contribution is taxable because it is in addition to the tax-free contribution. The difference between the maximum allowable government contribution and the total annual contribution determines the amount of contribution eligible for the catch-up contributions. Catch-up contributions are not taxable except in the case of military service pay, where the full amount will be taxable.
Also, withdrawal from TSP will incur taxes at the time of withdrawal, at ordinary income tax rate.
Differences Between The Two
If you want to put money into an investment that will allow you to save on taxes now, you likely have two different choices: a Roth IRA or a 401K or similar Thrift Savings Plan plan. Here is a comparison of these two plans.
What is a Roth IRA?
A Roth IRA is a personal investment account where you contribute money after taking a deduction for the money you put into the account. The way it works is similar in some ways to regular retirement investments where you save up over time and pay at the end. The difference is that you get a tax break initially rather than pay it back.
The Roth IRA is a hybrid, so you don’t have to wait until retirement to take out your nest egg. You can start taking your money out from the account once you’ve reached the age of 59 and a half.
While your investment will grow tax-free during its time in the Roth IRA account, there are some stipulations: 1.) You must wait five years before you can withdraw your money in the event that you are under the age of 59. 2.) You must withdraw the entire amount at once. You can’t pull out smaller portions of your funds.
What is a Thrift Savings Plan (TSP)?
This is a type of retirement account that is meant to be more like a short-term, custodial investment.
Which One Did I Do?
Both are intended for retirement savings at the government level. The type of savings that the government encourages citizens to do may not be the best option for your personal savings.
The advantages of the Thrift Savings Plan (TSP) are it invests in the stock market (as opposed to just bank certificates of deposits) and there is no income tax on the growth of the investment.
The advantages of the Roth IRA are that it is after-tax money and it can be withdrawn at any time without any penalty.
Which one should you invest in is a personal decision based on your current employment tax situation. It may seem like a hard decision because you don’t know where you will be in twenty years so I’ll save you the trouble and tell you what I did.
First I worked for several years as an engineering consultant. Since I was only an employee and not an owner in private company, I was not allowed to participate in the Company Retirement Savings Plan. Halley Consultants was a small business with probably a dozen employees who were partners in the company, so employees were not permitted to participate.
So I decided to enroll in the Thrift Savings Plan since it was the closest equivalent to the 401 K plan that a private business would have.