When setting up your retirement account, there’s a good chance you’ll be asked whether you want the traditional version or the Roth.
At first it might not seem like a big deal, but the reality is that your decision could impact your financial situation today — and in the future.
Here’s what you need to know about the differences between traditional and Roth accounts, and how to figure out what’s the right move for you.
Roth vs. Traditional: Taxes
Most savers recognize that the traditional versus Roth decision is most likely with an individual retirement account (IRA). However, there is also a Roth version of the 401(k), and employers are increasingly providing access to this choice.
The main difference between a Roth and traditional account is when you pay your taxes on the money you earn.
Traditional. With a traditional IRA or 401(k), you pay taxes on a deferred basis. When you contribute to a traditional IRA, you receive a tax deduction, decreasing your taxable income today.
With your 401(k), your employer takes the money from your paycheck before taxes are figured, effectively reducing your taxable income. Later, when you withdraw the money from your account during retirement, you pay taxes on it at your marginal rate.
Roth. On the other hand, a Roth contribution is made with after-tax dollars. If you contribute through your employer, taxes will be taken from your paycheck and the contribution made to your Roth 401(k).
If you contribute to a Roth IRA, you won’t be able to deduct the contributions at tax time. However, your money grows tax-free, so when you withdraw from your retirement account later, you won’t have to pay taxes on the money.
Understanding this core difference in when taxes are collected is vital when making the decision to put your contributions in a traditional or Roth account as you work to reach your goals.
Eligibility Rules Apply
There is an eligibility difference between a Roth IRA and a Roth 401(k) to keep in mind.
While both types of accounts have their own contribution limits, the Roth IRA also has an income limit. If you make a certain amount of money, you can’t contribute to a Roth IRA. The Roth 401(k), on the other hand, has no income eligibility requirement, so it’s possible to make contributions at any income level — as long as your employer offers a Roth 401(k).
Realize, too, that depending on your income and your access to a retirement plan at your work, your ability to deduct contributions to a traditional IRA might be limited. There’s a phaseout on the tax deductibility of traditional IRA contributions, so you might not get that benefit, depending on your situation.
Deciding Between a Roth or Traditional Account
Your first step when deciding how to proceed is to double-check your eligibility for the account you want to open.
With an employer-sponsored 401(k), eligibility isn’t going to be much of an issue. However, if you’re opening an IRA to supplement your tax-advantaged retirement savings or because you don’t have access to a plan at work, eligibility matters.
Next, consider your potential tax situation.
In many cases, the general recommendation is to choose a Roth account if you think your taxes will be lower today than they will be in the future. If you think you’ll pay lower taxes today, making your retirement contributions with after-tax dollars and letting that money grow tax-free can mean tax savings down the road.
In some cases, especially for those just starting with a first job and without a lot of income, a Roth can make sense because they might not owe federal income tax anyway.
On the other hand, if you think your tax bill is likely to be lower during retirement than it is now, it can make sense to use a traditional IRA or 401(k). You’ll reduce what you pay today in taxes, and later, you’ll be taxed at a lower rate.
Other items to take into consideration when making this choice include:
— Some employers won’t match Roth 401(k) contributions even though they match traditional 401(k) contributions. If you want to get the free money from a match, you might have to choose a traditional 401(k).
— There’s no predicting what might happen with tax law in the future. Will Roth protections disappear? Also, even if you’re making less money in the future, tax bracket changes could still put you in a higher bracket, costing you more.
— It might make sense to combine your strategies. Perhaps contribute to a traditional 401(k) to get a full match, but then, if you’re eligible, open a Roth IRA, or put a portion of your contributions into a Roth 401(k).
— Consider using a health savings account as part of the equation, if you’re eligible.
— Consider speaking with a financial professional to help you navigate the situation and review your options.
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While there’s no predicting the future, the reality is that setting aside money for retirement today is still likely to be a good move that benefits you in the long run — whether you use a traditional or a Roth account.
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