Why Traditional IRAs are (usually) better than Roth IRAs for FIRE
/
As a new member of the Financial Independence community, I finally decided to contribute to a Traditional IRA instead of a Roth IRA for 2020!
Why a Traditional IRA?
A Traditional IRA is typically better choice to contribute to a Roth IRA if you’re going for Financial Independence Retire Early (FIRE). Theoretically you’re making more now than after you become Work-Optional. After retiring early, you’d be making much less than at your 9-5.
Therefore, it would be better to get a tax deduction now by contributing to a Traditional IRA. You’d only be taxed on the Traditional IRA money once you slowly move it to your Roth IRA post-FIRE. So for tax purposes post-FIRE, your reported income would be made up of the money you converted to your Roth IRA plus the dividends you’re receiving from your stock investments.
For me, I anticipate yearly expenses to be ~$35,000 plus whatever I move to my Roth IRA. So for the most part I’d mostly be in a much lower tax bracket (12% vs. 22%) than right now—here are the current tax brackets.
Side note: I’m not factoring real estate into this FIRE strategy. Most of the FIRE people I follow (Our Next Life, Mad FIentist, JL Collins) did it through index fund investing alone. Plus, financially it doesn’t make sense to invest in real estate in my HCOL area. The article that inspired me to contribute to a Traditional IRA is by the Mad Fientist. He gives a lovely breakdown on his blog.
Except if you earn too much…
There is one very, very KEY 🔑 detail that I overlooked when implementing this IRA strategy. I won’t qualify for a Traditional IRA tax deduction because I’m on track earn too much this year. Noooo my plans have been foiled! 😞
You only qualify for a Traditional IRA tax deduction if your Modified Adjudged Gross Income (MAGI) is less than $75K. If your MAGI is less than $125K contribute directly to a Roth IRA. If you’re a super high earner (read: BALLA 😎 ) and your MAGI is over $125K, then you would still need to contribute to a Traditional IRA and then once you max it, immediately do a Backdoor Roth IRA Conversion.
This “problem” 😭 I have is really a blessing, but I didn’t realize this would be an issue until I had already opened, contributed and invested it. If you are in the same boat I am, all hope is NOT lost!
How to course correct if you just started investing in a Traditional IRA & are unqualified for the deduction
Similar to a Backdoor Roth IRA Conversion you can still recharacterize (convert) contributions to a Roth IRA. My concern was that I’d already bought shares in my Traditional IRA account and since we’re in a bear market, I’d have to sell at a loss and lose out on money I’d put in.
However if I do a Full Recharacterization of my entire Traditional IRA, I’m able to convert everything to my Roth IRA without selling. This would only work if you just opened and contributed to your Traditional IRA for the first time and haven’t taken any distributions from it. 🙌
THANK THE TAX GODS and more specifically a person named Kim 😊 in the Choose FI Facebook group. It was there that I initially asked what I should do regarding my dilemma and Kim gave me the above answer within 15 minutes. Glad there is a huge community of smarter and more knowledgeable people than me to help guide my FI journey. And hopefully this helped you too!
xo, Catie
Disclosure: Some of these links are affiliate links, meaning, at no additional cost to you, I may earn some compensation. All opinions are 100% my own! I truly appreciate you and your support. :)
