Traditional vs. Roth Retirement Accounts

In a recent interview, Erin Kennedy and Tom O’Connell discussed the difference between traditional and Roth retirement accounts. Most people are familiar with how their 401(k) and even their IRA works, but Roth accounts have not been as commonly used. However, they can be a useful component of your retirement strategy and reduce your overall tax burden.

What’s the Difference between Traditional & Roth Accounts?

A traditional retirement account uses your pre-tax dollars to fund your nest egg. That means more money can go into the account and grow, and you postpone paying income tax on the money you contribute to those savings into the future. When you retire, you will pay taxes on the income you receive from a traditional retirement account, in what many are predicting to be a much higher tax environment.

A Roth account is basically the opposite. You will pay income taxes on your money now, then use that taxed money to fund your Roth account. The money then grows in your account until you receive distributions. But when you retire, you don’t have to pay taxes on your income. Not having to worry about income tax during retirement is the biggest advantage Roth accounts offer.

Why Would You Choose to Pay Taxes Now instead of Later?

Most people would automatically choose to pay taxes later instead of now. After all, that’s more money in your pocket right now, which you can use for investing and other purposes. But what you may not realize is that personal taxes are currently pretty low, and they are certainly not going down.

In fact, the federal government has already announced that taxes will go up in the future. In fact, according to the Congressional Budget Office, the government plans to take 30% more from personal income taxes over the next 5 years than they are receiving today. That’s a big difference for the taxpayers. If taxes are lower now, it actually makes more sense to pay at the lower tax rate today and receive your distributions tax-free.

You Might Benefit from Having Both

Not every 401(k) has a Roth component. It really depends on the type of plan you have. But you may contribute to your Roth 401(k) at work and take advantage of the lower personal taxes today. It’s important to understand that any employer contributions to your 401(k) will still be on the traditional side, and you have to pay taxes on those earnings when you receive distributions in retirement.

If your 401(k) doesn’t allow you to select a Roth component, ask your employer to add that as an option. Your financial advisor may encourage you to have traditional and Roth retirement accounts to take advantage of tax savings now and in the future.

Choosing between a traditional and a Roth retirement account isn’t as straightforward as you might think. It’s a good idea to talk to a financial advisor about the tax implications of your investment decisions to ensure you don’t pay more than you need to.