Could the right savings decision mean a tax-free Cadillac? Source: Wikimedia Commons.
If you're a freelancer trying to decide between a Roth and Traditional retirement savings contribution (whether to your IRA or 401(k)) you may feel a little lost.
After all, while the traditional rule of thumb is to think about whether your income tax burden will be higher in retirement than it is now before making a decision, the fact is that you can't be sure what your income tax situation will be later on.
As a business owner (and even if you just freelance occasionally, you should always think of yourself as a business), you often have no idea what your income tax situation will be next year.
So, all you really have to go on is what's happening today; everything else is a matter of career growth, government policy, and the vagaries of life. That's why you should consider managing your risk by contributing to both Roth and Traditional accounts.
What's the difference again?
Traditional IRA and 401(k) contributions are made "pre-tax," meaning that when you make a contribution you don't pay income taxes on that amount. Of course, when you take withdrawals from the account in retirement, you'll pay taxes at whatever your current income tax rate is.
On the other hand, Roth IRAs and 401(k)s take post-tax dollars, so you do pay taxes today but you won't pay taxes on withdrawals later on.
So, to put it simply, with a Roth you save on taxes tomorrow, while with a traditional account you save on taxes today.
Mitigating risk
The logic behind Roth accounts is that by foregoing immediate tax benefits, you're giving yourself the opportunity to get big payoffs later -- this is especially true if your income level rises substantially or if income tax rates go up.
At the same time, today's tax benefits are also valuable. Using pre-tax dollars means you can contribute more to your retirement account, which is one of the best things you can do for it. It also means less taxes paid from your business -- a major win.
So, both accounts are valuable. Now add the uncertainty: You don't know what income tax rates will look like, nor will you know how your own income and career shapes up.
Solution: Contribute to both
By contributing to both Traditional and Roth accounts, you can enjoy tax benefits today and tomorrow.
First off, you're not bypassing the value of lower income taxes right now. For some business owners, that can mean the difference between struggling and feeling like you're getting ahead, or reinvesting into the business for future growth.
At the same time, you're protecting your future self from income taxes.
This might not sound compelling right now, but your future self could be leading a pretty lavish lifestyle thanks to all that reinvestment into your business. Shelter that amazing man or woman by putting some money in a Roth -- even if it's just enough to finance holidays and/or a vintage Cadillac, you'll be very happy that it was a tax free holiday or vintage Cadillac.
How do I do it?
The mechanics of the decision ultimately rest on three things:
- Your tax situation today
- Your business situation
- Your budgeting
For my own business, my focus is on optimizing today's taxes -- that's partly because it's small and growing and I need all the savings I can get, and partly because I want to free up capital to reinvest.
However, I still set aside a chunk of my "salary" (the word salary sounds strange to me, considering I work for myself, but that's another story) for savings. Once this amount reaches a certain point, a chunk of it is diverted to long-term savings -- this is where a Roth account will really come in handy.
It's money I already paid taxes on, and I'm saving it anyway, so why not set it up for tax-free growth?
You can do the same with your own business situation: What's your tax strategy this year? Where are you going? And finally, how can you make your retirement savings decisions work for you to the greatest possible extent? The answers will tell you whether a Roth or traditional IRA -- or a combination of both -- is the best solution for you.
