Understanding your options for retirement accounts can be quite daunting. It can take time to figure out what strategy is best for you; choosing Roth vs. traditional accounts, maxing out an IRA or a 401k, and optimizing your plan. We’ll go through the basics of Roth vs. traditional accounts below!
What is a Retirement Account?
Retirement accounts are powerful investment accounts because they are tax-sheltered (sometimes called tax-advantaged). This means that you won’t have to pay taxes each year on the money your investments make (like interest, dividends, and capital gains). Money in these accounts will compound rapidly thanks to these tax breaks. Additionally, initial contributions to retirement accounts can be tax-deductible.
To clarify, a retirement account is not an investment itself. Instead, it is the location for an investment or pool of investments. You can think of it like a brokerage account (with benefits!).
There are many different types of retirement accounts. Many of them have the option between selecting a traditional or a Roth version.
Roth vs. Traditional
There are two types of retirement accounts: traditional accounts and Roth accounts. The major difference between the two types is when you pay taxes for the account.
Deductions are parts of your income shielded from taxes. For example, you can deduct charitable contributions from your taxable income—for income tax purposes, it’s as though you never earned the money that you so generously donated to the Red Cross.
You generally contribute pre-tax money to traditional accounts by claiming deductions on your contributions (deferring your tax payments to a later date). This is not a tax dodge; you’ll have to pay taxes on withdrawals from traditional accounts. Essentially, you’re agreeing to pay taxes later with a traditional account.
In contrast, contributions to Roth accounts aren’t deductible, but you won’t have to pay taxes on your withdrawals. With a Roth account, you’re agreeing to pay taxes now and never be taxed on that money again.
“I’ll pay my taxes later!” —Mr. Traditional
“I’ll pay my taxes now!” —Ms. Roth
When Each Option Makes Sense
How should you decide which type of retirement account is best for you? There are a few factors you should consider:
- How much money are you currently making? If your income is currently low, a Roth account may be best for you because you’ll be able to take advantage of your current low-income tax rates. Similarly, if your income is currently high, you should consider a traditional account because you want to avoid paying your currently high-income taxes since you would presumably be making less in retirement.
- Do you have plans now that would benefit from tax breaks? If you really need money now, you probably want a traditional account to pay less taxes this year.
- Are tax hikes on the horizon? If you suspect that income taxes might be higher during your retirement than they are today, you’ll probably want a Roth account—you might as well pay your taxes now while they’re still relatively low.
- Is my income level low enough to contribute to a Roth account without tax penalties? Roth accounts are especially great because you’ll only ever have to pay taxes on your contributions since withdrawals are tax-free. This means that any earnings your account makes will never be taxed! This is probably the reason that there are income limits for contributing to Roth accounts. Check the IRS’s website to see whether your income level qualifies.
Note that “traditional” and “Roth” are simply terms used to describe the general tax strategy a retirement account uses—it’s not enough to say “I have a Roth account.” Instead, you’ll say “I have a Roth IRA” or “I have a traditional 401(k).”
Choosing Your Retirement Strategy
As always, make sure to consult with a licensed financial professional to thoroughly go over your retirement options. Each strategy has its own benefits and drawbacks. One strategy may make sense for a CEO making $300,000 per year, while a different one may be best for a paralegal making $50,000. There is not always clear answer in the battle between Roth vs. traditional retirement accounts. It all depends on your situation.
When in doubt, look at the opportunity cost of your strategy. Does it make sense to take a tax deduction now with a traditional account that can be reinvested into a business that you are working on? Or does it make more sense to take care of taxes now and remove the risk of higher tax bills in the future?
Retirement accounts are investment accounts with great tax benefits. Your investments will grow fastest within a retirement account.
However, it is important to understand the benefits and drawbacks that come with investing in Roth vs. traditional retirement accounts. Your optimal tax strategy could save you thousands, all of which can be poured back into your retirement nest egg.
Regardless of what type of account you use, it’s best to begin contributing to retirement accounts as soon as possible. Since their earnings aren’t taxed, they will compound faster than most taxable accounts. Set yourself up for success earlier rather than later!