Last time we looked at the differences between two types of retirement accounts: a 401(k) and an IRA. This week I'd like to examine the characteristics of traditional retirement accounts (such as a 401(k) or IRA) vs. Roth retirement accounts. So which type is more appropriate for you?
Here's a recap of traditional retirement accounts from last week's post. You deposit earned income into the account. The account balance grows (we hope) and this growth is not taxed. When you take the money out after you've reached retirement age, withdrawals are taxed according to your income at that time. There is also a hefty penalty if you take funds out before age 59 1/2.
Some employers offer a Roth option for your 401(k) or other type of retirement account. Even if it's not offered through your employer, anyone can open a Roth IRA at a brokerage house. Each account type has specific requirements for yearly contributions, so check to be sure you're meeting the account's parameters.
1. You must have earned income to contribute to either a traditional or Roth retirement account.
2. Investment gains are not taxed in either account.
A Roth retirement account is different from its traditional counterpart in a few key ways.
1. In a Roth account, your money is taxed now. That's right, it's taxed before it goes in the account. When you take money out of the account at retirement age there is no tax because you already paid income tax before the money was contributed.
2. Contributions to a Roth can't be deducted.
3. There aren't any required minimum distributions (RMDs). In other words, you can leave money in the account for as long as you want.
4. Contributions to a Roth account are less restrictive than a traditional account and can be taken out without penalty after a five year period. This makes it a tool that can potentially be used for other goals besides retirement (if appropriate).
The IRS has more information on Roth IRAs here. Additionally, it's recommended that you check with your tax professional regarding the specifics of your unique situation.
Which account should you contribute to?
As a general rule of thumb, Roth contributions are good if you have lower income now than you anticipate having in the future. If your tax bracket goes up in retirement, then contributing to a Roth is most effective. If your tax bracket is lower in retirement than when you're working, a traditional retirement account will leave you with more funds (all other things remaining equal).
If you need flexibility with the funds, a Roth might serve you well. However, it's important to note that there are limited circumstances where this is appropriate. It's difficult to get funds back into the account to grow for retirement. Therefore, you only want to take those funds out if you've done careful planning to be sure you're balancing multiple goals.
I often recommend that clients split the difference. Meaning they contribute some retirement funds to a traditional account and some to a Roth account. Because we don't know what tax legislation will be in the future, having money in two different "buckets" gives you more flexibility for tax planning. One advantage to the Roth is that the tax consequences are already known.
Next week's post, the final of our retirement basics series, will take a somewhat different direction. Instead of the merits of different account types, I'll address the main things to consider for retirement savings and investing given your age so that you can most effectively SaveUp!
This post was written by SaveUp's personal finance contributing writer, Catherine Hawley, CFP.