In my previous article, I explained why I believe that many soloprenuers don't necessarily need to start their retirement savings with a traditional small business retirement plan. For many soloprenuers still in the start up phase, all they may need is a Roth IRA. Why?
The future potential of a Roth contribution outweighs any current tax savings from contributing to a pre-tax plan. Contributions to a Roth are withdrawn tax free. All other plans are taxed at your current income rate upon withdrawal. So if your Roth grows to $1 million, it's all tax free. The idea of saving on your taxes may seem obscure, but it really can pay off.
Example. Suppose a 25-year-old contributes $5,000 each year into a Roth until she retires and makes an average annual return of 8% on her investment, she'll have $1.4 million saved by the time she retires at age 65. And the money is all hers -- she won't have to give the IRS a cent of it if she waits until 59 ½ years old to cash out.
If that same 25-year-old invested that same $5,000 a year in a pre-tax retirement plan earning the same 8% return, she'd only have about $1 million after taxes if her withdrawals were taxed at 25% federal. That's one-fourth less money than if she'd gone with the Roth. If she owed state taxes on the money too, she'd be down even more.
Obviously, I am pro-Roth for the simplicity of ownership and tax advantages. The Roth has some other advantageous provisions:
You can take money out in a pinch. Although the purpose of a Roth is to save for retirement, and your money can grow only if you leave it in the account, you can withdraw your contributions at any time, tax free and without penalty -- and you don't have to pay it back, like you do with a 401(k). Any earnings you withdraw WOULD be taxed if you withdrew it before 59 ½ years old, plus you'll have to pay a 10% penalty.
You can tap your Roth to buy your first home. The IRS lets you cash out up to $10,000 from your Roth IRA tax- and penalty-free -- which can include earnings -- to help you achieve the American dream. However, the account must have been opened for five years. You could use tax-free money from your IRA to buy a house starting in January 2014. That $10,000 limit is per person, so couples could withdraw up to $20,000. If you don't meet the five-year test, you still can take out the money for your home purchase, but you'll have to pay taxes on it. You won't have to pay the 10% early-withdrawal penalty, though.
You can start small with a Roth. Many custodians of traditional small business retirement plans want a minimum contribution of $1,000 to start an account, whereas if you open a Roth, you can save into it monthly in denominations as little as one dollar (although that may not be the best use of your money if you can only contribute $1 per month).
So if you have been thinking about setting up some retirement savings, I encourage the soloprenuer to seriously consider the Roth IRA. Happy savings!