There are numerous types of “qualified” retirement accounts—too many to tackle in an article that you will enjoy reading. But one frequent question regarding retirement accounts is, “What is a Roth account?”
Traditionally, contributions made to either 401(k) accounts or Individual Retirement Accounts (IRAs) are tax-deductible and grow tax-deferred. Therefore, you invest money that you have never paid tax on and your investment grows without any tax until you withdraw it. However, when you withdraw from your account (after age 59 ½), you pay tax on the full amount at your ordinary income tax rate at the time of the withdrawal. If you take a withdrawal before age 59 ½, you pay both taxes and a 10% penalty.
What’s the difference between a traditional contribution and a Roth contribution? With Roth contributions, you do not get the benefit of tax-deductibility today, but you do not pay any tax when you withdraw from the account, so you avoid tax on the investment growth.
So which is best for you? Of course that depends on what your tax rate is today, and what it will be in retirement. However, guessing what your tax rate will be 10, 20 or 30 years from now is essentially impossible. So, consider these other factors:
- With Roth IRA contributions, you can withdraw your contributions (but not investment earnings) without incurring any additional tax or penalty. This may provide a safety net in an emergency situation where you need to access your account before age 59 ½. With traditional contributions, accessing the funds requires paying tax and potentially a 10% penalty on the amount withdrawn.
- Income limitations. Your income level may prevent you from contributing directly to a Roth IRA, or from making tax-deductible contributions to a traditional IRA (if you and/or your spouse are eligible for an employer’s plan). If you are subject to these limitations, or think you may be, talk to your advisor about a strategy often referred to as “Back door Roth IRA.”
- Not all 401(k) Plans offer a Roth deferral option, but that should not prevent you from maximizing your contribution to a traditional 401(k).
The bottom line: There is no definitive answer as to whether Roth or traditional contributions are better for your retirement planning. Consider these factors, talk with your CPA or financial advisor and do not let the confusion keep you from saving!