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Are you currently earning money? If the answer is yes, are you saving for retirement? An important part of saving for retirement is deciding whether to put money into a Roth retirement account (401(k) or IRA) or a traditional retirement account. Choosing your retirement savings type wisely could help you avoid paying more taxes than necessary.
When you are making the decision where to invest your retirement savings, consider the following four areas: your tax bracket now and in the future, your employer’s match, your retirement account beneficiaries, and the savings you already have.
Think of retirement accounts as a farmer who plants seeds:
A Roth account holds “after-tax” money, or money you have already paid the income taxes on. Its qualified distributions are tax-free: you pay taxes on the seeds, but the harvest, which is hopefully much larger than the seeds, is tax-free.
A traditional retirement account has pre-tax money: you don’t pay income taxes on the seeds (either by taking a tax deduction or deferring from your paycheck before taxes); you pay the income taxes on the harvest when you withdraw the money.
When deciding whether to contribute to a traditional retirement account or Roth account, consider the following:
Is your tax bracket lower today than your tax bracket will be in retirement?
Anticipating tax rates can be difficult, as no one has a crystal ball about how Congress may change tax rates in the future. If you know you are earning less today than you will in the future (for example, you’re just starting in a career), then a Roth account may be the best option.
On the other hand, if your income is at its peak, a traditional account may be the best option.
Another option is to consider splitting your savings between the 401(k) and Roth 401(k).
Does your employer match your retirement contributions?
If yes, then your employer is already contributing to a traditional 401(k), so consider contributing to the Roth 401(k) to diversify your retirement account types.
If you cannot save enough to max out your employer’s match, consider a traditional 401(k).
Who are your beneficiaries?
If you are leaving money to charities, consider using a traditional retirement account since the charity is exempt from income taxes.
If your children are your beneficiaries, consider whether your children will be in a lower tax bracket after your death than you are now. (Some people choose to give their children the additional gift of prepaying the taxes and leaving the children tax-free money in a Roth account.)
Will your required minimum distributions (RMDs) provide more money than you need?
If you already have money saved in a traditional retirement account, the government will require you to take minimum distributions at age 70 ½. (A good rule of thumb for your first distribution is to divide your account balance by 26.)
On the other hand, a Roth IRA requires no distributions at a certain age, which means the money can continue to grow tax-free until you need it.
Diversifying your retirement savings between traditional and Roth accounts can be important because during your retirement you can choose to withdraw taxable money from your IRA or tax-free money from your Roth IRA. Just like a farmer plants different types of seeds, you may want both traditional and Roth retirement funds to choose from when you are retired. For more information about deciding whether to contribute to a Roth or traditional account, see the following article from Charles Schwab & Co.
Always seek the advice of a professional financial planner and a CPA when considering the tax effect of your savings.
