So, you’ve started a new job. Maybe it’s your first job, or maybe you’ve decided to continue your career with a different company.
As you begin your new job, you’ll also be setting up contributions into a retirement account.
This could be an IRA or an employer-sponsored plan — such as a 401(k), 403(b), etc. — and your choice will be based on several factors, including eligibility and availability.
Within these tax-advantaged retirement accounts, you may also have the opportunity to choose whether you’ll contribute to a traditional or Roth account. But, which one is better for you?
The basics of tax-advantaged retirement accounts
First, it’s helpful to know what the benefits are of both traditional and Roth accounts.
Traditional IRA, 401(k), etc.
A traditional account is a pre-tax qualified account. This means that any contributions you make during the year are tax-deductible, lowering your income for the tax year in which you make the contributions.
Since traditional accounts are tax-deductible, distributions will be considered ordinary income when you take money out in retirement. Therefore, you will have to pay income tax on your distributions.
With traditional accounts, you are subject to required minimum distributions (RMDs) beginning as early as age 73 (for some younger individuals, RMDs start at age 75).
Roth IRA, 401(k), etc.
A Roth account is an after-tax qualified account.
Because your contributions into a Roth account are after-tax, you won’t receive a tax deduction for your contributions. Instead, your Roth contributions will grow tax-free!
Distributions in retirement aren’t considered income, so you won’t pay any income tax on Roth distributions.
Additionally, Roth accounts are no longer subject to RMDs, meaning you are never required to make a distribution.
The difference between traditional or Roth accounts
Both traditional and Roth accounts are great options as you begin to build your retirement savings; as long as you are contributing to at least one account, you will be better off financially in the future than if you didn’t.
The difference between traditional or Roth accounts basically comes down to when you want to pay your taxes.
By contributing to a Roth account, you are choosing to pay your taxes today.
Conversely, when you choose a traditional account, you pay your taxes as you take distributions in the future. And because the taxes are deferred, you can decide when you want to incur them and when you want to continue to defer — that is, up until RMDs start at either age 73 or 75.
Choosing the right account for me
There are several factors that affect the decision-making process between a traditional or Roth account, such as current income, expected retirement income, future tax rates, state income tax, and the list goes on.
The simple answer to this question is: If you are in a lower tax bracket today than you expect to be in during retirement, all else equal, it makes the most sense for you to contribute to a Roth account.
If the opposite is true, and your tax bracket today is higher than you expect your retirement tax bracket to be, you should consider selecting a traditional account.
Unfortunately, the simple answer isn’t always the most effective.
First, this is assuming that we know what tax rates will be in the future — which, unless one of you has a crystal ball you would like to share with the rest of us, is nearly impossible to predict.
On top of that, a lot of factors can change between now and retirement. You might not be working in the same line of work, which can affect both your current and future incomes.
In addition, you might not even be living in the same state as when you first began contributing. Each of these things can affect the tax savings from choosing one account type over the other.
If you would like to take a deeper look at which tax-advantaged retirement account is better for your retirement planning goals, reach out to me and we can start a conversation!
And, stay tuned for part two of this blog post: where we’ll take a further look at how your choice between traditional and Roth accounts can affect your finances.
