When it comes to retirement planning, one of the first decisions you’ll face is whether to go with a traditional or Roth retirement account. Whether you’re choosing between an employer-sponsored plan (like a 401(k) or 403(b)) or opening an individual retirement account (IRA) on your own, this is an important choice to make. But how do you know which one is right for you? Let’s break it down.
Roth vs. Traditional: It All Comes Down to Taxes
The main difference between Roth and traditional retirement accounts is when you pay taxes on your contributions and earnings. It’s essentially a matter of when you’ll face the tax bill: now, or later.
- Traditional retirement accounts (like a traditional 401(k) or IRA) let you contribute pre-tax money. This means that the money you contribute lowers your taxable income for the year. However, when you retire and start withdrawing from the account, you’ll pay taxes on the money you pull out.
- Roth retirement accounts, on the other hand, require you to pay taxes on the money you contribute upfront. This means that your contributions are made with money you’ve already paid taxes on. The major perk? When you withdraw the money in retirement, it’s tax-free. This can be a great option if you’re looking for tax-free income down the road.
In short, choosing between Roth and traditional comes down to whether you’d prefer to pay taxes on the seeds (Roth) or the harvest (traditional).
How to Choose: Consider Your Income Now vs. Later
The decision largely depends on your current income and how much you expect to make in retirement.
- If you’re in a higher tax bracket now and want to lower your tax burden today, a traditional account might be the way to go. By contributing pre-tax money, you’ll reduce your taxable income this year, which could be beneficial if you’re making a decent salary.
- If you’re in a lower tax bracket now or anticipate being in a higher tax bracket when you retire, a Roth account may be your best bet. Paying taxes on your contributions now means you won’t have to worry about paying them later when you’re hopefully making more money in retirement.
Additional Considerations for Roth vs. Traditional Accounts
There are a few more factors to keep in mind as you decide which option is best for you:
- Early Withdrawals from Roth Accounts: One of the big benefits of a Roth IRA is that you can withdraw the money you contributed (but not the earnings) at any time without penalty—once the account has been open for at least five years. Of course, retirement accounts are meant for retirement, but this can provide flexibility in case of an emergency.
- Required Minimum Distributions (RMDs): For traditional retirement accounts, the IRS mandates that you begin taking Required Minimum Distributions (RMDs) at age 72 (or 73, if you turn 72 after December 31, 2022). This means you’ll have to start withdrawing and paying taxes on the money whether you need it or not. Roth IRAs, however, don’t have RMDs during your lifetime, which can be a great way to pass on your wealth to heirs.
- Income Limits: One key consideration is your income. If you’re earning a high income, you might be restricted from contributing to a Roth IRA because of income limits set by the IRS. For traditional IRAs, anyone can contribute, but whether you can deduct your contributions from your taxes depends on your income and whether you have access to a retirement plan at work.
The Right Choice for You
It’s important to think about your unique financial situation before making a decision. A CERTIFIED FINANCIAL PLANNER™ (CFP®) can help you assess your tax situation, long-term goals, and retirement needs to make the best choice. Whether you go with a Roth or traditional retirement account, both offer powerful ways to save for retirement—you just need to figure out which one fits your financial picture.