Retirement Accounts: Roth vs. Traditional

You have several different options for retirement accounts, but they all operate similarly. Whether you have an IRA, 401(k), 457(b), or something similar, you typically have two options when making contributions: pre-tax or post-tax.

A pre-tax contribution is the traditional method. Your contributions are deducted from your taxable income for the year, meaning you don’t have to pay taxes on your contributions during the tax year you made the contribution. Your contributions grow tax-free until you start making withdrawals. Withdrawals are taxed as ordinary income. For example, if you made $100,000 this year and contributed $10,000 into a retirement plan (i.e. a 457(b)), your taxable income would only be $90,000. If that $10,000 grew to $50,000 when you retire and you withdrew all of it, you would be taxed as if you earned an additional $50,000 that year.

A post-tax contribution, or Roth contribution, is made with after-tax funds. In other words, you do not receive a tax break when you make contributions, but you are not taxed on any of your withdrawals, including any gains you have made on your investments. For example, if you contributed $10,000 into your retirement plan today and at retirement it was worth $100,000, you would get the $90,000 in gains completely tax free!

Traditional accounts can be good for people who anticipate paying lower taxes in retirement since that will likely result in a lower tax bill. It can also be good if you need the tax breaks now.

Roths can be a good choice for people who will likely pay lower taxes today than in the future. For example, people who are just starting their careers will likely pay less taxes today before their lifetime of raises starts. Roths can be a better choice if you are expecting hefty returns on your investment because none of those returns will ever be taxed. Also, if your account is five years old, you can withdraw your contributions from a Roth account at any time without being taxed or penalized.

You can also choose to contribute to both a Roth and a traditional retirement account in the same year. This would allow you to enjoy some tax deferrals today while also having a source of tax-free income in the future.

Whether a traditional or Roth account (or a mixture of the two) is best for you depends on your individual circumstances. There are more considerations than what was discussed in this article, so consult your plan administrator or a financial planner if you have questions regarding which may be better for you.