Once someone begins retirement planning, one of the first decisions he or she must make is whether to use a traditional (pre-tax) account or a Roth account. Both options have pros and cons or best-use cases. I’d like to share a brief overview of both options and make a case for why both can be a part of your retirement readiness plan.
First, let’s take a look at the key differences between the two options.
Traditional (Pre-Tax) accounts
- Anyone with earned income can contribute.
- Contributions are tax deductible.
- Distributions are taxable.
- Required minimum distribution begins after age 70½.
- Tax filing status income limits restrict who is eligible for Roth IRAs (does not apply to employer-sponsored Roth accounts).
- Contributions are not tax deductible.
- Qualified distributions are tax-free on both the contribution and the earnings.
- Roth IRAs have no required minimum distributions. (Employer-sponsored Roth accounts do have RMDs.)
- Contributions can be withdrawn any time prior to age 59 ½, tax and penalty free.
As you see, a variety of differences exist between traditional and Roth accounts. Depending on your current and future tax situation, one type may be more beneficial than the other at different points in life. Generally, workers early in their careers benefit more from Roth accounts because they are (typically) in a lower tax bracket than they will be in retirement.
As a person matures throughout the working years, the tax benefit shifts to favor pre-tax contributions, as wages tend to reach a higher tax bracket currently than expected in retirement. This is the primary deciding factor regarding the type of contributions to make or the type of account to open: “When do I want to be taxed on my contributions?”
Since both types have competing tax benefits, this is a great way to diversify your retirement savings. Not only should you look at diversification in investment types, but also regarding your tax situation. The biggest concern is to contribute regularly to your retirement savings. However, with the tax implications of pre-tax and Roth contributions, you can better prepare for whatever your future tax situation is by having both types of accounts.
Each person’s tax and financial situation is unique. Special rules or exceptions may apply, but seeking out opportunities for tax diversification should be considered for everyone’s retirement plan. If you would like more information on how these types of accounts work and what options are available for you, please contact the Board of Retirement and allow us the opportunity to assist you in your retirement planning.
See IRS Publication 590-A for more details on Individual Retirement Arrangements.