When deciding on which type of retirement account to contribute to there are many misconceptions and confusions regarding which type is optimal. Oftentimes people will mistakenly ask if they should contribute to a 401k or an IRA when in reality that is the incorrect question to ask. The correct question individuals should ask is whether they should contribute to a Traditional vs. a Roth account. Basically all types of accounts from IRA’s, SEP, 401k, etc. have the ability to contribute to either Roth, Traditional, or a mix of the two – the only information still needed is which one is better for your long term goals.
Roth Account
A Roth account (AKA Post tax account) – Retirement account where taxes are paid NOW but pay no taxes later even though the account is growing from investments.
This kind of retirement account does NOT get to be deducted from your taxable income each tax year, instead the amount within the account gets to grow tax free for as long as you have the funds in the account.
Money must stay in the Roth account for at least 5 years before taking any distribution or you may have to pay a 10% early withdrawal penalty
There is an income limit to be able to contribute – in 2021 you can only get the full contribution amount if your AGI is less than $125,000 (single filer) and $196,000 (Married Filing Joint)
Who is the Roth account good for? Individuals who:
- Expect their taxable income will be higher in the future than it is currently
- Expect Federal Tax rates will be higher in the future
- Are early in their careers and expect career growth
- Who plan to have lower income in specific years can consider Roth contributions in those years (I.e. if you traveled the country for half a year and only earned half a year of income)
- Who want to hedge against variable future tax rates
- Are young adults working entry level jobs and have no taxable income during a certain year
- Are dependent young children who receive earned income (i.e. child actors, other income sources received while very young)
Traditional Account
A Traditional account (AKA Pre tax account) – Retirement account where taxes are deferred but taxes are paid on withdrawal as ordinary income. This kind of retirement account IS DEDUCTED from your taxable income each tax year, however the amounts within the account are taxed upon withdrawal.
Similar penalties occur for early withdrawal as the Roth account, where distributions taken before retirement age set by the IRS is subject to penalty.
There are no contribution limits on traditional IRAs but the deduction may be limited if you or your spouse is already covered by a plan at work.
Who is the Traditional account good for? individuals who:
- Expect total taxable income to be lower in the future than it is currently (people who are OK taking less pay in retirement than they are living on currently)
- Expect federal tax rates to be lower in the future
- Who are near the peak of their career growth or don’t want/expect substantial wage increases in future years
- Individuals who plan to have large amounts of charitable contributions in the future – can donate QCD’s to both get the tax benefit and avoid payments on distributions
- Individuals who cannot & don’t want to fund Roth accounts
For more information – get booked for a call with your Booked Financial Rep
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This tax information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Booked Financial LLC recommends that you consult with a qualified tax advisor, CPA, financial planner, or investment manager. Depending on the type of account you have, there are different rules for withdrawals, penalties, and distributions. Please understand these before opening or contributing to a retirement account.