An overlooked, but important, part of any retirement savings plan concerns the type of account you use. Investment accounts typically fall into one of three categories: Taxable, Tax Deferred, or Tax Free. This article will focus on the distinction between tax deferred and tax free accounts since these are the most commonly used accounts due to their tax preferences. Since taxes will represent a significant portion of your lifetime expenses (sad, but true), the decision on which account to use for your savings is important when building your nest egg.
What is a Traditional Retirement Account?
Traditional retirement accounts provide a tax deduction on the amounts contributed in the year they are contributed. Future growth in the account is tax-deferred and taxes are due upon distribution years later. The amount that can be contributed annually to a traditional retirement account is based on certain factors such as income, age, and availability of workplace retirement plans. Additionally, there is a required minimum distribution (RMD) at age 72 for traditional IRA account holders, however recent changes to the RMD rules have pushed this age to 73 and eventually to 75. Traditional retirement accounts are often referred to as Tax Deferred Accounts, since the taxes due on them are deferred into the future.
What is a Roth Retirement Account?
Roth retirement accounts were created in 1997 and are named after Senator William V. Roth Jr. Roth accounts operate a bit differently in that contributions are not tax deductible, but distributions in the future can be taken completely tax free. The rules can get a bit complex, but it is important to note that contributions to a Roth IRA can be taken out at any time for any reason tax and penalty free. Conversions to a Roth IRA have a different set of rules, and it is important to understand the “5-year rule”. The amount that can be contributed annually to a traditional retirement account is based on certain factors such as income and age. Roth IRAs have no required minimum distributions (RMDs) during the account holder’s lifetime. Roth retirement accounts are often referred to as Tax Free Accounts, since distributions are often completely tax free (although there is a relative tax impact on contributions when compared to a Traditional account).
Decision between a Traditional and Roth IRA
The choice between a Traditional IRA and a Roth IRA depends on individual circumstances, such as income level, tax bracket, and retirement goals. For some people, a Traditional IRA may be more advantageous because of the tax-deductible contributions, which can lower their current taxable income. However, these tax savings will be offset by taxes on withdrawals in retirement, when the account holder may or may not be in a higher tax bracket. For others, a Roth IRA may be more advantageous because of the tax-free withdrawals in retirement. With a Roth IRA, contributions are made with after-tax dollars, so there are no tax benefits at the time of contribution, but all withdrawals, including investment gains, are tax-free in retirement.
It is recommended to consider factors such as the current tax situation, expected tax bracket in retirement, and overall financial goals before making a decision between a Traditional IRA and a Roth IRA.
Strategies for Savers
- Roth Conversion – Making traditional contributions in your highest tax bracket years, and then making Roth conversions in years that have comparably lower tax rates can be an efficient way to increase your tax-free retirement income without sacrificing the tax deduction in your highest earning years.
- Backdoor Roth IRA – Contributions to a Roth IRA are phased out at certain income levels. A backdoor Roth IRA strategy addresses the income limitation by making a “non-deductible” traditional contribution followed by a conversion to Roth. If done correctly, there will be no taxes due on the conversion and a funded Roth IRA account. Check with your tax advisor or financial professional if this is a good move for you – it does require some extra steps compared to a regular contribution.
- RMD Changes – Beginning in 2033, the age for RMDs will move to 75. This expanded window can provide for significant tax-planning strategies, including the timing of asset sales and more time to convert additional funds to a Roth for income and tax planning.
- The Barbell Strategy – No one really knows what their future tax rate will be. A way to hedge against the risk of unknown future tax rates would be to simply split your savings and allocate half to traditional retirement accounts and half to Roth retirement accounts. While not a magical solution to the retirement puzzle, it beats doing nothing!
The main takeaway is that not all accounts are created the same, and the right account for you will depend on your situation – there is no one size fits all solution when it comes to retirement planning. Educate yourself, ask questions, and as always – invest early and invest often!
What I love the most about personal finance is that it’s personal. Where do you stand on the Roth vs. Traditional debate? I would love to hear your thoughts. Please send them to commoncents@Northbrookfinancial.com.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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