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Choosing Roth or Pre-Tax Savings Retirement Accounts

When saving for retirement, you have several options, but two of the most common are a Roth or traditional IRA/401K. Both help you save for retirement and have tax advantages, but a Roth offers tax advantages during retirement, while a traditional retirement account offers them now.There’s a big difference between the two; not strategizing your retirement plan could leave you with less money than anticipated.So, it’s important to understand how to choose between the two. In a perfect world, most people have both, but it’s important to understand the differences and how they affect your retirement income and taxes.

What is a Roth Retirement Account?

A Roth retirement account offers tax-free growth and withdrawals. You contribute funds after paying taxes on them, and the money you contribute and the earnings grow tax-free.When you withdraw the funds in retirement, you don’t pay taxes. This can make a tremendous difference in your retirement money, especially if you’re in a higher tax bracket. There is one downside. You can’t contribute to a Roth IRA account if you make too much money. In 2023, the income limits are $138,000 – $153,000 for single filers and $218,000 – $228,000 for married filing jointly couples. The contribution amount is phased out in that range. Roth 401k’s on the other hand do not have any income limitations, however not all employer retirement plans offer a Roth feature.

Other Benefits of Roth Accounts

• No Required Minimum Distributions
• You can contribute for as long as you want, as long as you have earned income
• Your beneficiaries will benefit from tax-free withdrawals from inherited Roth accounts

What is a Traditional Retirement Account?

A traditional retirement account allows you to contribute funds on a pre-tax basis. You get the tax break today, and your earnings and contributions grow tax-deferred. However, there’s a catch. When you withdraw traditional funds in retirement, you pay ordinary income tax rates on the amount withdrawn.This means you’ll have much less money in retirement than anticipated and may have to save more to reach your retirement goals. If you’re in a high tax bracket during retirement, it could foil your retirement plans, leaving you with much less money in retirement.

Benefits of Traditional Retirement Accounts

• You lower your tax liabilities today
• You can contribute to a traditional retirement account no matter your income

The Goal with Retirement and Taxes

The key when investing for retirement is to reduce your taxes over your lifetime, not just the year you contribute. Yes, that tax deduction can feel great at the moment, but it’s a one-time deduction. When you withdraw traditional funds during retirement, you’ll pay tax at your ordinary income tax bracket, which decreases the funds you receive for your daily cost of living. So not only will you have less money in hand, but you’ll also have a big future tax problem that could have been avoided if you strategized your retirement plan early on.

Why Tax-Free Income is Better

So why is tax-free income better? It’s simple.

You’ll need to take less money from your retirement accounts when you have a Roth account. This is because when you don’t have to account for taxes, you withdraw what you need. For example, if you have $1 million saved for retirement and need $40K per year to supplement your other retirement income, you’d withdraw $40K per year if you have a Roth account.However, the amount needed to be withdrawn from a traditional retirement account to generate $40k look much different. For example, let’s say you’re in the 22% federal and 5% state tax bracket. You’d need to withdraw $54,795 yearly to net $40K for living expenses. Suddenly, that $1 million retirement account won’t go as far, and you might need to find ways to supplement your retirement income to live comfortably.

Ways to Take Advantage of Both

In a perfect world, you’ll utilize a traditional and Roth retirement account to take advantage the current and future tax benefits that each account type offers. Here are a few ways to make it happen. Backdoor Roth Conversions If you didn’t qualify for a Roth IRA or wanted the tax deduction in the year you contributed, consider converting your traditional retirement accounts to Roth accounts in the future. This gives you the best of both worlds. You get the pre-tax contributions now and then pay the taxes in the future to convert the account before retirement. To get the largest benefit out of this strategy, you should plan your conversion in a year when you’re in a lower tax bracket and can save money on your tax liabilities while setting yourself up for a more financially stable retirement.

New Employer Roth Matching

Under the new SECURE Act 2.0, employers may permit employees to elect matching contributions to be made to Roth accounts. This is a drastic change from the old rule that only allowed matching to be made to traditional pre-tax accounts. Employer matching made to a Roth account is taxable to you in the year the matching contribution was made, but this will help boost your tax-free bucket of money for retirement when you won’t have to pay taxes on the amounts withdrawn.

Mandatory Roth Catch-up Contributions for High Earners

If you’re over 50, your catch-up contribution requirements will change. In 2024, if you are over the age of 50 earning more than $145,000 and make catch-up contributions, they must be in a Roth account, not a traditional retirement account. This means the catch-up contributions will be after-tax. While this doesn’t provide tax relief now, you’ll enjoy it during retirement when you can withdraw the funds tax-free as long as you’ve held the account for five years.

Final Thoughts

Choosing Roth or pre-tax savings retirement accounts is a big decision. Finding a way to maximize both accounts gives you the best of both worlds and increases your chances of having enough money in retirement.The last thing you want to spend time worrying about is if you’ll have enough money in retirement, so careful retirement planning now will increase your chances of success in retirement. Consider Roth and pre-tax accounts, taking into consideration the pros and cons of each, but maximizing your retirement funds that are tax-free, so you have more money in your pocket and less financial strain from tax liabilities.