- The decision to make Traditional or Roth contributions to retirement plans adds an extra layer of complexity to investing.
- Traditional contributions allow participants to defer tax until funds are withdrawn, while Roth contributions allow participants to pay tax up front, so there’s no tax obligation upon withdrawal.
- When deciding what type of contribution to make, consider what you qualify for, your current and future tax situation, your time horizon, if you may need to withdraw early, and what your goals for the money are.
When saving towards a financial goal, whether it’s retirement or anything else, tax considerations are a critical piece of the puzzle. In plans such as IRA’s and 401(k)’s you can’t decide whether or not you pay taxes on the savings you’ve accumulated, but you can choose when you pay taxes. The IRS gives you the option to pay them now, or pay them later by allowing you to make traditional or Roth contributions. Choices can be a good thing, but they can also add an extra layer of complexity when investing. In this post, we will explain how traditional and Roth contributions work and which may be a better fit for your portfolio.
How they work
For years, retirement plans have given participants the opportunity to save money within a vehicle that provides tax-deferred growth. This means that even if a stock in your account is sold or a dividend is paid, you don’t owe any tax while your funds are in the account. The result is that more money stays in your account, allowing the compounding of interest to work its magic! Another tax benefit the government created to incentivize people to contribute to retirement accounts: they were given a tax deduction for the money that was put into a traditional retirement plan. This is called making a pre-tax, or “traditional,” contribution. Given that no taxes are paid up front, participants are able to lower their current year’s adjusted gross income and pay taxes on their savings only when the funds are withdrawn in retirement. Let’s look at an example:
EXAMPLE 1: Mary’s salary was $100,000 in 2013. She made traditional contributions of 10 percent (or $10,000) of her salary to her company 401(k) plan. Since her contributions are tax deductible, she reduced her taxable income by 10 percent, resulting in adjusted gross income (AGI) of $90,000 for Mary in 2013.
In IRA’s and most 401(k)’s however, you are given a second contribution option. This option is called a “Roth” contribution, named after Senator William Roth of Delaware who co-proposed this alternative retirement savings idea back in 1989. The Roth option allows participants to pay taxes on their retirement savings up front so they never have to pay taxes on the money again! Let’s consider an example of a Roth:
EXAMPLE 2: Mary’s salary increases to $110,000 in 2014. Again, she decides to make a 10 percent (or $11,000) contribution to her 401(k), only this time she elects to make it a Roth contribution. Her AGI will remain at $110,000 for the current year, meaning no tax deduction is received up front. However, when she withdrawals the money in retirement, she won’t pay any taxes on her contribution or earnings.
Look for Part 2 of this blog, where we’ll discuss which contribution may be best for you, in the coming days. If you have questions about what contributions are right for you, please feel free to email me, or please call the office number at (610) 895-8070 and we’ll be happy to discuss.