YOU MIGHT QUALIFY to fund both a tax-deductible and Roth IRA. Alternatively, perhaps your employer offers the chance to stash money in either a tax-deductible or Roth 401(k). Which should you favor?
It’s a question of whether you want cake today or cake tomorrow. Roth accounts offer tax-free growth but there’s no immediate tax deduction. Traditional retirement accounts usually offer an immediate tax deduction but everything withdrawn in retirement is taxed as ordinary income. When choosing between the two types of account, think about whether your tax bracket in retirement is likely to be higher or lower than it is today. If you expect your tax rate in retirement to be the same or higher, you should favor the Roth, giving up today’s tax deduction in return for tax-free growth.
Conversely, if you think you’ll be in a lower tax bracket in retirement, you should opt for traditional retirement accounts, passing up the Roth’s tax-free growth and snagging the immediate tax deduction instead. You’ll take that tax deduction at your current high tax rate, while knowing you’ll pull those dollars out of your traditional retirement accounts at a lower tax rate once you’re retired. Many folks will be in this camp. The reason: You can deduct today’s retirement account contributions at your marginal tax rate, which could be 22% or higher. But in retirement, your retirement account withdrawals might be your only income—and thus you’ll probably pay taxes at an average rate that’s well below 22%.
What if you’re unsure what your retirement tax rate will be? You might hedge your bets, dividing your money between traditional and Roth accounts. With all the uncertainty surrounding both your own financial future and the U.S. tax code, “diversifying” your retirement accounts like this might be the prudent choice.
While tax considerations often favor traditional retirement accounts, a Roth IRA might still be appealing, thanks to some unique advantages. Unlike a traditional IRA, you can withdraw your regular annual contributions from a Roth IRA at any time for any reason. Just put $6,000 in a Roth? You can pull that money out tomorrow with no taxes or penalties owed.
Under current law, you also don’t have to take required minimum distributions from a Roth IRA once you turn age 72. That means you can leave the account to continue growing tax-free, and you might even bequeath the account to your children or other beneficiaries. A Roth IRA can make a fine inheritance, giving your beneficiaries a pool of tax-free money that they can leave to grow for up to 10 years after your death.
Like the idea of sidestepping required minimum distributions with a Roth IRA? If you fund a Roth 401(k), be sure to transfer it to a Roth IRA before you reach your 70s, because minimum distributions are required from a Roth 401(k). Avoiding required minimum distributions is also a reason to convert a traditional IRA to a Roth IRA.
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