The evolution of our tax code has created an alphabet soup of retirement account options, making our choice of investment accounts for retirement confusing. A case in point being the difference between a Roth IRA or 401k, and a Traditional IRA or 401k. A personal financial manager can help you understand these differences, as well as helping you decide which will be the most benefit to you and your financial goals.
What is the difference between a Roth IRA or 401k, and a Traditional IRA or 401k? Simply, contributions to a Traditional IRA or 401k are made pre-tax, reducing your current tax burden, while Roth contributions are made post-tax. However, during retirement, distributions from a traditional IRA are taxed as ordinary income while Roth account distributions are taken tax-free. Growth is tax-free in both cases – no capital gains tax or tax on investment income is assessed on assets in either plan.
The way the math works, if tax rates stay exactly the same, the Roth and the Traditional IRA/401k will end up with the same after-tax retirement benefit in the future. If tax rates go up, however, the Roth delivers higher after-tax income in retirement. In other words, when deciding among investment accounts for retirement, a Roth IRA or 401k is a wonderful hedge against higher taxes at retirement. When you consider the current fiscal crisis and the level of debt this country has built over the past decade, an environment of rising taxes is likely. By investing in a Roth plan, you can protect some of your retirement income from higher tax rates.
Roth vs. Traditional IRA/401k
- Roth IRA contributions are limited based on income. HOWEVER…many employer 401k plans now have a Roth 401k option. These plans do not have income limitations.
- Distributions from Roth accounts are tax free in retirement. Although you receive no tax deferral when you contribute to your plan, a Roth can be an effective strategy to hedge against higher taxes in the future. Balancing your retirement dollars between Roth and Traditional retirement plans adds a layer of diversification of future income sources and a way to hedge your retirement tax bills.
- In a Roth account, there is no annual minimum distribution required at age 70 ½ as there is with a Traditional plan – so tax free growth can continue throughout your lifetime. This can be a terrific tax-efficient strategy for leaving assets to your kids – while still having those assets available to you during your lifetime.
- Converting an IRA from traditional to Roth is another way to build Roth assets into your financial plan and also has no income limitations currently. However, when you convert, income taxes are due on the amount converted. A competent personal finance planner or tax advisor can help you create a conversion strategy.
Many people believe they will be in a lower tax bracket in retirement because they won’t be earning as much – concluding that a Roth plan does not make sense for them. However, unless you will be relying mostly on Social Security Income in retirement, chances are that your taxable income in retirement will be high because distributions from Traditional retirement plans are taxed as ordinary income.
A Roth IRA or 401k provides a powerful strategy to hedge your retirement tax bills and extend your tax-free growth benefit. If your employer provides a Roth option in your 401k plan, you have easy access to building your Roth retirement accounts.
At Tamarind Financial Planning, we will use our individual financial planning strategies and personal investment management techniques to help you decide whether you can benefit from a Roth, as well as exactly how to best diversify your investments for retirement.