Roth vs. Traditional Retirement Savings: Which one is right for you?
Retirement looks different to everyone, but one commonality is financial independence and the ability to enjoy post-work life. The keys to success start many years before retirement, in fact, they should start when you begin your first job. Building good saving habits early is instrumental to a successful retirement. There’s often confusion about the types of retirement accounts, the benefits and taxation, the ability to contribute, and the maximum contribution amounts. This blog will take a closer look at IRAs and Employer Sponsored Plans.
Individual Retirement Accounts (IRAs) are long-term retirement savings vehicles designed for individual investors and are classified as Roth or Traditional. IRAs can be opened and managed at most major custodians and are generally not included as an employer benefit.
Let’s look at Roth vs Traditional IRAs from a high level. When you see the word Traditional, think pre-tax. Contributions made to a traditional IRA are tax deductible and therefore will NOT be included in your taxable income. These contributions are then invested and grow tax-deferred. After age 59 ½, withdrawals will be taxed at your ordinary income rates. In the event you make a withdrawal before 59 ½, that distribution will be taxed at ordinary income rates with a 10% penalty. (Certain exceptions apply to avoid the penalty). Remember--these accounts are designed for long-term savings.
At age 72, you will be required to make withdrawals from your Traditional IRA called required minimum distributions (RMDs). You haven’t paid taxes on the original contributions or growth, and Uncle Sam needs to be paid!
When you see the word Roth, you should think after-tax contributions. Your Roth IRA contributions are not tax deductible, therefore ARE included in your taxable income. Once you reach 59 ½, funds can be withdrawn tax-free and there are no RMDs - you never have to withdraw money from Roth IRAs if you so choose. Why? Because Uncle Sam has already gotten his tax money, you paid upon your contribution.
Now let’s talk about who can contribute to an IRA. Anyone with earned income can open and contribute to a Traditional IRA. The maximum contribution in 2022 is $6,000 if under age 50, and $7,000 if 50 or above. However, your contribution is subject to phase outs based on your Modified Adjusted Gross Income (MAGI).
If your MAGI is higher than current income limits, you can still contribute to a Traditional IRA. However, you cannot deduct your contributions. The advantage to this strategy (called a Non-Deductible IRA) is the ability to immediately convert your Non-Deductible IRA to a Roth IRA. Given you have already paid taxes on the contributions, the Non-Deductible to Roth IRA conversion is usually tax free. As this is a more complicated strategy, you should consult a financial advisor for guidance.
When it comes to contribution limits for the Roth IRA, you need to have earned income AND make less than a certain amount in order to be able to contribute. The income phase outs differ from the Traditional IRA in that if your MAGI falls in these ranges you may be able to partially contribute, but if it exceeds the phase outs you are not eligible to contribute.
More phase out information can be found on Nicole’s blog here.
Now let’s move on to company sponsored plans. Here is where you should be thinking 401ks, 403bs, 457s, TSPs, and so on. These are retirement savings accounts that are offered through your employer. Not all companies offer a Roth option on their plan, but a vast majority do. Let’s use a 401k Plan that offers a Roth option and a 3% employer match as an example.
Scenario 1: Employee elects traditional 401k contributions:
Employee contributions AND the employer match will both be treated as traditional contributions, or pre-tax. (Currently, employer matches are always pre-tax.) Upon withdrawal, all withdrawals will be taxed as ordinary income. If you leave your job and rollover your 401k, you would receive one check with all contributions and earnings combined.
Scenario 2: Employee elects Roth 401k contributions:
The employer match will still go in as a pre-tax contribution, but your employee contributions will be Roth (after-tax). You can think of your Roth 401k as two buckets, one for your Roth contribution and one for your employer’s pre-tax contributions. If you were to leave your job and rollover your 401k, you would receive two checks, one for the Roth portion and one for the traditional.
Two big differences between the IRA and the company sponsored plan are the contribution limits and the phase outs. In 2022, an employee under age 50 can contribute $20,500 to a 401k. Additionally, there are NO Roth income limitations or phase outs. Anyone with earned income can contribute to a Roth 401k.
Now that we understand the difference between Roth vs Traditional taxation and IRA vs company sponsored plans, let’s look at a few important considerations before making a decision.
A major consideration is your current tax bracket. Using myself as an example, I am (hopefully) in one of the lowest tax brackets of my life. As I get older and advance my career, I will make more money and naturally accumulate more assets. This will in turn elevate my tax bracket. In this example, it would be very advantageous to get my taxes paid now, and then withdraw tax-free later in life when I’m at a higher tax rate. Looking specifically at a Roth IRA, we previously mentioned that there are income phase outs. The opportunity to even contribute to a Roth IRA could be limited depending on your income. It’s another important reason to make the most of retirement savings in the first few years on employment.
On the flip side, let’s look at a married couple in the last few years before retirement. These last few years will likely be their highest earning, and therefore their highest tax bracket. In this situation, it may make sense to contribute to a traditional IRA or 401k. In this example, when they retire and no longer have income from employment, they may fall into a lower tax bracket. So, contributing pre-tax now and being taxed in retirement could be to their benefit.
Leaving Roth assets to beneficiaries is another consideration. With the SECURE Act of 2020, all inherited IRAs regardless of Roth vs Traditional need to be liquidated within 10 years. Previously, you could take withdrawals based on the beneficiary’s life expectancy. Leaving Roth assets to beneficiaries will allow them to make withdrawals tax-free, while a Traditional Inherited IRA will impact their tax situation.
In conclusion, multiple factors should be taken into account before selecting your retirement savings options. For young earners like myself, Roth accounts are a great way to get started.
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