If any contentious debate exists among the financial nerds it is the showdown of which retirement tax advantages to choose: Is it better to invest in traditional or Roth accounts?
Both Roth and traditional accounts are tax-advantaged, meaning you pay fewer taxes than a regular brokerage account. In a typical brokerage account, you pay taxes on the money you contribute initially and you also pay taxes on any growth of your investments when you withdraw the money, based on your income at the time you withdraw the money.
In other words, contributing to any tax-advantaged account before contributing to a regular brokerage is a smart move. However, which should you choose?
Tax-Advantaged Accounts in the Tax Battle
There are two major types of accounts affected by this tax battle:
You may remember that HSAs are also tax-advantaged accounts that can be used as a retirement vehicle, but since they are triple-tax-advantaged, you can realize the benefits provided by a Roth account and a traditional account if you use the money from your HSA on qualified medical expenses.
Both employer-sponsored retirement accounts, like the 401(k), and IRAs offer the Roth or traditional option. Some employer-sponsored retirement plans still do not offer the choice: Until recent years, 401(k)s only offered traditional account options. Since the choice between Roth and traditional is fairly new for 401(k)s, you may find that your employer only offers a traditional 401(k) without a Roth option.
It is also important to note that even if you choose a Roth 401(k), your employer’s matching contributions will be traditional. Sadly, employers remain unwilling to pay taxes now so our future retired selves can enjoy tax-free returns on our employer matching contributions.
What’s the Difference?
Both Roth and traditional accounts, whether 401(k)s or IRAs, exempt you from taxes at one stage over the life of your money. Traditional accounts shield you from taxes on your initial investment, while Roth accounts shield you from taxes on your future gains.
When you invest in a traditional account, you pay no taxes on that money up front. Your contribution deduction lowers your taxable income for the year you contribute, resulting in a lower tax burden. For example, if you make $150,000/year but contribute $22,500 to a traditional 401(k), your taxable income decreases to $127,500. That other $22,500 is tax-free!
Your amount invested then grows tax free, but you do have to pay taxes eventually. When you withdraw in retirement, you must pay taxes on the entire amount withdrawn, including original contributions and any growth, based on your current income tax rate.
When you invest in a Roth account, you pay taxes up front based on your current income rate. Your taxable income does not decrease like it does with a traditional account since you are paying taxes on the money.
The Roth investment also grows tax free. However, when you withdraw from your Roth account in retirement (assuming you are at least age 59.5 and have had your Roth account for at least five years), you realize the tax advantage. You withdraw the money completely tax-free, meaning you never have to pay taxes on that growth!
The Traditional Argument
The main argument to contribute to a traditional 401(k) and/or IRA is to realize an immediate tax break and enjoy a lower taxable income. If you have a traditional account, you will experience the tax advantage of the account when you file for the current tax year. Having a lower taxable income allows you to be more flexible if you have a diverse portfolio or are experiencing large taxable gains (a good problem to have!) in another area of your finances.
The argument for realizing the tax break immediately as opposed to sometime in the future hinges on the notion that when folks are still employed, their income is likely to be higher than when they are retired. When you retire, you no longer need to commute to work, buy new suits, or purchase a number of conveniences that largely support you working. Expenses like childcare expenses become obsolete, and life expenses are generally simpler. You may even have paid off your mortgage. You need less money to live a comfortable retired lifestyle than to support an active working lifestyle. Thus, the argument goes, you should pay taxes in retirement, when you are in a lower tax bracket.
However, this logic assumes that tax brackets will remain the same or at least similar between the current year and the time you withdraw the funds in retirement. If you are only a couple years from age 59.5, that is a safer bet than if you are 30 years away.
The Roth Argument
If you do not believe tax brackets will remain constant, particularly if you believe they will go up considerably, a Roth account may better suit you. The United States currently enjoys lower taxes per capita than most European countries, but it also has a growing national debt that may complicate these relatively low tax rates going forward. None of us can predict the future and know how much tax rates will change, if at all, by the time we reach the age we plan to withdraw our retirement funds, but it is prudent to formulate an educated opinion on what you believe to provide logic to your unique financial path.
A second factor to choose a Roth is to have more individual control over your money in retirement and experience a more predictable retirement plan. If you know you paid taxes already, a significant tax bracket shift occurring when you are 80 years old will not hurt your plans. You can plan to use the entire balance of your Roth account for your retirement rather than pay it towards taxes at unpredictable rates.
Similarly, Roth accounts also avoid required minimum distributions (RMDs). RMDs begin when an individual turns 72 through 75 (depending on year of birth). The law mandates that traditional IRA account holders withdraw a certain amount each year based on their age, life expectancy, and account balance. While you will probably want to withdraw some of this money, many folks prefer to control the precise timing of their withdrawals and do not appreciate government restraints that require them to pay taxes.
Additionally, Roth accounts provide more flexibility if you need to withdraw money before age 59.5 (which is particularly important if you plan to retire early!) and additional options to beneficiaries after your death.
But What Should You Choose?
That is up to you! It is often framed as a choice between a short-term (traditional) or long-term (Roth) benefit, but it is somewhat more nuanced. If you believe your income is much higher now than it will be in retirement and tax brackets will not change, will shift down, or will only rise slightly, then you are probably on team traditional. If you believe your income will be higher or similar in retirement than it is now and/or tax brackets may rise considerably, then you are probably team Roth. Most of us have to weigh a few competing principles to determine where we fall.
Here is the most important part: Even if it takes you time to consider your own perspective, contribute somewhere now! You can contribute to a traditional account, read a few books, and then decide Roth is the right path for you. It is still better to contribute to either account than to miss out on tax-advantaged growth. We can agree to disagree on Roth vs. traditional, but when it comes to contributing to any tax-advantaged account, there is a right answer: Contribute now.
*We use “401(k)” to discuss factors that are true for all types of employer-sponsored retirement accounts. In any case where there are differences, they are specified. The specific type of account available to you is based on your employer type. For example, only federal government employees can participate in the Thrift Savings Plan.
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