When saving for retirement, you’ll have to decide between a traditional account with upfront tax breaks or a Roth with delayed ones. Here’s how to choose.
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When you invest for retirement, you may have a few options for what kinds of tax-advantaged plans to use to save for your future. It’s important that you pick the right one, as it could make a big difference in how much you ultimately have to spend as a retiree.
The biggest choice you’ll have to make is whether you want to save on income taxes when you make your contribution or as a senior. If you prefer the former, then you’d need to opt for a traditional IRA or a traditional 401(k). If you prefer the latter, then a Roth would be best.
A traditional IRA or 401(k) allows you to claim an upfront deduction in the year you contribute money to your retirement plan. Any distributions as a retiree will be taxed. A Roth 401(k) or Roth IRA doesn’t offer the upfront tax break, but you can make tax-free withdrawals. With these accounts, you either save on taxes when you contribute to your account or when you withdraw your money — but not both.
So, how can you decide if you’re better off with tax savings now or in the future? Here are some key things to think about to help you make that choice.
Does your employer offer a Roth 401(k)?
If you want to contribute to a workplace 401(k) plan, you may have only one choice: a traditional account. More employers offer traditional accounts than Roth accounts, although this is changing over time.
If your only option is a traditional 401(k) and your employer offers matching contributions, you should invest enough to get the match no matter what — even if that means you’re claiming your tax breaks now when you’d prefer to do it later. A match is free money, and no tax benefits are worth passing that up.
If you have a choice of a traditional or a Roth 401(k), you have a tougher decision to make and will need to ask yourself more questions.
Of course, if a traditional 401(k) is your only choice, you also have the option to invest enough to get the match and then move the rest of your money into a retirement account you open at a brokerage firm of your choosing. This way, you can pick between a traditional or Roth account instead of letting your employer make the choice for you.
If you’d prefer to pick yourself when to claim your tax breaks (or you like the other benefits a brokerage account provides, including broader investment choices), then consider taking this approach.
Do you think you’re paying more in taxes now or will pay more later?
It makes sense to claim your tax savings at a time when your rate is the highest.
If you claim an upfront tax break when your tax rate is at 22%, the maximum tax savings your contribution will provide you is 22%. If you pass up the tax savings upfront and claim it later and your tax rate as a senior is 37%, the maximum you could save is 37%. In this case, you’d be better off with a Roth so you could save up to 37% rather than saving up to 22%. But if you had a 15% tax rate as a retiree, you’d have been better off with a traditional account and saving the 22% instead of 15%.
There are several factors that determine if your tax rate is likely to go up or down. If you make less money as a senior, you could be in a lower tax bracket, so your tax rate will be lower. If that’s the case, a traditional account and upfront tax savings is best. But if your income as a retiree is higher than when you are working, you could be in a higher bracket later, so a Roth would be best.
There’s also a chance tax rates will go up across the board, as rates remain low by historic standards and there’s fairly broad support for increasing rates on at least wealthy Americans. If you believe rates overall will go up, then your rate may be higher as a senior even if your income is the same or less than it is now. In this case, you may be better off opting for a Roth and deferring your savings.
By taking these two big issues into consideration, you can decide whether you should use a traditional account and claim your tax breaks now or whether you should opt for a Roth and wait until later. Ultimately, the decision depends on your future financial projections as well as what kind(s) of plans your employer is offering.
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