Retirement vehicles come primarily in two forms Traditional and Roth. These are most commonly found in IRAs (Individual Retirement Accounts) or 401(K)s. They are both tax-advantaged vehicles designed for long-term savings and investments, to help people plan for their long-term goals, such as retirement.
Each type of account has its own advantages and disadvantages. The right account for you will depend on your current situation and long-term goals. As such, it is always best to work with a licensed financial advisor to create a plan together to achieve your goals.
Commonalities
Roth and Traditional accounts are tools available to individuals to help save money for long-term goals, typically retirement planning. They each have tax advantages, that can minimize the long-term tax payments to the IRS, if used properly.
Because of the tax saving benefits, they do come with strings attached. For example, if you try to take a withdraw from an IRA account under the age of 59.5, you may have to pay an additional 10% tax for early withdrawals unless you qualify for an exception. Exceptions for IRAs, 401(K)s, and other retirement saving vehicles can be found here at the IRS’ website.
When putting money into the accounts, they each have a maximum amount you can contribute. For IRAs, the annual contribution limit for 2020 is $6,000 or $7,000 if you are age 50 or older. The IRS discusses each year’s IRA contribution limits here.
For 401(K)s, the contribution limit for employees is $19,500. Employees aged 50 and over have the option to contribute an additional amount into their 401(K) via the Catch-Up provision. This allows individuals to contribute an additional $6,500 to their saving plans. The IRS discusses this in more detail here.
Differences
The primary difference in these vehicles is how they deal with tax free growth. It all depends on when do you pay your income’s taxes to the IRS – now or later?
Traditional vehicles deduct contributions immediately, if you qualify. This means you pay the Federal Income Tax on the contributions to the IRS now and get a tax-free withdrawal after the age 59.5. As such, for those that are looking for an immediate benefit to their taxes, a Traditional account will provide tax advantages up front. A Roth account is the reverse. You do not pay the Federal Income Tax until you withdraw the funds.
Around the age of 72, Traditional IRA account owners will be required to take a minimum distribution (RMD) from their funds, while Roth IRAs are excused. RMDs are the minimum amount a person must withdraw from their account each year. The withdrawals will be included in your taxable income except for any part that was taxed before or that can be received tax free such as Roth accounts.
RMD rules apply Traditional IRAs, as well as SEP IRAs, Simple IRAs, 401(k) plans, 403(b) plans, 457(b) plans, profit sharing plans and other defined contribution plans. They are not required by Roth IRAs.
If you do not take any distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required. To understand the minimum distribution requirement, click here for the U.S. Securities and Exchange Commission Required Minimum Distribution Calculator.
Your Decision
There are pros and cons for each vehicle and widely dependent on your goals and situation. Always speak with a licensed Financial Advisor or accountant to help determine which method is best for you.
The biggest difference between a Roth account and a Traditional account is how and when you get a tax break. As such, a vital question you must ask yourself is, do I expect my tax rate will be higher or lower in the future?
By focusing on this question, it can help determine which path may provide the biggest tax benefit to you. While the future is always changing, it may be difficult to anticipate what your tax rate will be in retirement, especially when this is decades away.
If you are anticipating a lower tax bracket during retirement, a Roth account may be right for you. While if you are expecting a higher tax bracket, you may want to consider a Traditional account.
The better you are able to think long term and plan accordingly, the more you can save by minimizing taxes, allowing for a larger nest egg for you and your family in retirement.
Disclosure:
Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc. a Registered Investment Advisor. Cambridge and Langan Financial Group, LLC. are not affiliated.
