Author Topic: Roth vs. Trad for self-employed making 40K  (Read 2221 times)

Saving in Austin

  • Stubble
  • **
  • Posts: 171
Roth vs. Trad for self-employed making 40K
« on: April 27, 2016, 04:41:04 PM »
I'm going to help a friend open a new Vanguard account tomorrow.

She is a self-employed massage therapist making 40K per year.

She is about 30 years old.

We live in Texas so there are no state income taxes.

Would you recommend Roth or Traditional at that income bracket?

seattlecyclone

  • Walrus Stache
  • *******
  • Posts: 5400
  • Age: 35
  • Location: Seattle, WA
    • My blog
Re: Roth vs. Trad for self-employed making 40K
« Reply #1 on: April 27, 2016, 05:42:10 PM »
How much is she looking to save? As a self-employed person she could save more than half of her pay into tax-advantaged accounts (solo 401(k) plus IRA). If she saves enough into traditional accounts she could bring herself into an income range where the saver's credit and maybe even the earned income credit could apply. Those might be worth pursuing if she's looking to save a substantial amount.

Saving in Austin

  • Stubble
  • **
  • Posts: 171
Re: Roth vs. Trad for self-employed making 40K
« Reply #2 on: April 27, 2016, 05:50:35 PM »
Thanks for this response. I will have to ask her.

I was thinking she could do an HSA for the tax deduction and a Roth for additional savings.

I don't know anything about solo 401K accounts.

I do a SEP IRA each year but I think it is in lieu of a solo 401K.

seattlecyclone

  • Walrus Stache
  • *******
  • Posts: 5400
  • Age: 35
  • Location: Seattle, WA
    • My blog
Re: Roth vs. Trad for self-employed making 40K
« Reply #3 on: April 27, 2016, 05:56:49 PM »
A SEP IRA lets you save a quarter of your earnings tax-deferred from the employer side. A solo 401(k) lets you do the same thing plus $18k from the employee side. For someone making $40k, this should essentially let you save as much as you can afford to put away.

Saving in Austin

  • Stubble
  • **
  • Posts: 171
Re: Roth vs. Trad for self-employed making 40K
« Reply #4 on: April 27, 2016, 06:50:20 PM »
This is a beginning investor without an early retirement point of view.

I'll present some of this stuff an as intro but she probably only has a few thousand to start with.

Thanks Again.

Proud Foot

  • Handlebar Stache
  • *****
  • Posts: 1083
Re: Roth vs. Trad for self-employed making 40K
« Reply #5 on: April 28, 2016, 09:40:53 AM »
Going off what you stated I made a few assumptions (Single, standard deduction, no additional credits).  If she is only looking to invest the $5,500 limit she would be better off right now doing the traditional IRA. It would save her approximately $825 on taxes.  Although her marginal rate is only 15% on income, being self employed adds another 15.3% for a total marginal rate of 30.3%.

bobechs

  • Handlebar Stache
  • *****
  • Posts: 1068
Re: Roth vs. Trad for self-employed making 40K
« Reply #6 on: April 28, 2016, 09:45:10 AM »
Following; not leading.

bacchi

  • Magnum Stache
  • ******
  • Posts: 4820
Re: Roth vs. Trad for self-employed making 40K
« Reply #7 on: April 28, 2016, 12:11:41 PM »
One good thing about a Roth is that the contributions can double as an emergency fund.

If she can save a lot, she can put some in a solo 401k to reduce her AGI and get the saver's credit.

seattlecyclone

  • Walrus Stache
  • *******
  • Posts: 5400
  • Age: 35
  • Location: Seattle, WA
    • My blog
Re: Roth vs. Trad for self-employed making 40K
« Reply #8 on: April 28, 2016, 02:30:15 PM »
About the saver's credit: it has some AGI "cliffs" where reducing your income by a single dollar could cause the credit to go up by a few hundred. The first such cliff is from a $0 credit to a $200 credit. This happens at $30,750 AGI.

For a self-employed person with $40,000 of business income, they will pay $5,652 in self-employment taxes. Half of this is deductible from AGI, leaving your friend with an AGI of $37,174 before other deductions. The regular tax at this income level is 15%, so a traditional retirement contribution of $37,174 - $30,750 = $6,424 would result in a tax savings of [$200 + (15% * $6,424)] = $1,163.60. That's an 18% tax savings on that money, which isn't bad.

Putting this money in a Roth account instead would then mean your friend would have to pay that $1,163.60 of taxes this year, but it would then grow tax-free. If she expects to have a tax bracket over 18% in retirement, this is a good plan.

The next saver's credit cliff is at $20,000 AGI, bringing the credit up to $400. There's a pretty narrow band until the next cliff at $18,500. Once you get there, the nominal credit is $1,000, but for most people it will just max out at whatever their tax was before the credit. As getting to this level would require your friend to save half her income, it probably isn't on the table right now, but it's good to be aware of if she manages to increase her frugality over time.