As an employee, saving for retirement is fairly simple. Your company offers you some type of retirement savings plan (usually a 401(k) or 403(b)), you set aside a percent of every paycheck to go into the plan, you choose from a limited set of funds to invest in and then you hope for the best. The process is easy and leads to many people participating in it.
As an entrepreneur, saving for retirement can be a little more tricky. With no employer to set up a plan, you are left to find your own ways to save money towards your retirement. Over the next two weeks we will discuss the best and most tax efficient ways small business owners can save for their retirement. Today we will talk about IRA’s and next week we will discuss setting up more formal retirement plans in your business.
The Best Financial Move You Can Make
As a CPA and financial advisor, I am often asked what the single best thing someone can do to improve their finances is. And my answer is always the same; open an individual retirement account (IRA). If you already have an IRA, my answer is to contribute more to it. If you are already maxing out your IRA, my answer is to open and max out a second IRA for your spouse. IRA’s are truly one of the very best tools available for significantly improving your financial situation.
If you are an entrepreneur, this is even more true. With no 401(k) or other employer sponsored retirement plan to contribute to, the importance of taking advantage of an IRA is more even significant. Not only will an IRA help fund your retirement someday, it could also be a serous tax deduction.
What is an IRA
An IRA allows you to contribute up to $5,500 ($6,500 for those 50 and older) of taxable income to a retirement account, which will either give you a tax deduction on the front end or tax free income on the back end, depending which of the two types of IRA’s you choose.
A Traditional IRA allows you to deduct the full amount of your contribution from your taxable income each year. Assuming you are in the 25 percent tax bracket, contributing the maximum of $5,500 in 2013 will give you a tax savings of almost $1,400. So not only are you setting yourself up for retirement, the IRS is wiping $1,400 off your bill to do it. What’s not to like?
A Roth IRA doesn’t give you the immediate tax deduction that a Traditional IRA does, but it does give you tax free income at the time of retirement. Any earnings that grow in your Roth IRA are allowed to be withdrawn completely tax free after the age of 59 1/2. Depending on when you began contributing, this could save you tens of thousands of dollars in taxes.
Which Option is Best
The decision to go with a Traditional or Roth IRA is dependent on your personal situation and beliefs. Some people believe in taking the guaranteed, immediate tax savings of Traditional IRA because of the uncertainty of the future with a Roth IRA. Other people believe you should take the option that offers you the most tax savings, regardless of when they will occur, which is usually the Roth IRA.
As a general rule, the younger you are, the more beneficial a Roth is over a Traditional IRA. There are also some income limitations around a Roth IRA, but those can usually be overcome with some tax planning. If you are having trouble deciding which IRA is best for you, a CPA or financial advisor can offer you advice on which will benefit you the most.
Just Pick One
Ultimately, which type of IRA you choose won’t have near as much of an impact on your retirement and tax savings as simply picking one and starting to contribute. If you change your mind later, you can always convert your IRA to a different type. The most important decision you can make with an IRA is to begin contributing as much as possible to one today.
Next week we will discuss retirement plan options for solo entrepreneurs.