Traditional or Roth? Which retirement account is better?
As young people when we think about retirement (if we even stop to think about retirement at all), we have the ability to go into a beautiful dream-scape. A space in our minds where we can envision whatever it is that we want for our lives.
If we want we can create that most ideal dream situation for ourselves in real-life, especially if we start early. Having a clear vision of the life you want is of course #1. But, it’s not the only thing you need to think about.
We do still live within a complex financial system that we need to navigate in order to achieve our big visions, once we have them. (If you’re not sure about the vision you want for yourself in retirement refer to this article for some useful tips on how to get started. And you can always just call on us and we would be happy to help you think your vision through.
Once you have your vision, it’s about learning how to finesse the tools for building your foundation. There’s two steps in there…
First, you need to learn how the tools and mechanisms work.
Second, you need to develop a strategy to get the most out of the system you are putting your money into.
And one of the most significant factors that impacts your money that you have to watch for, especially when it comes to significant amounts like the ones you are looking for in retirement is... taxes.
Yup, everyone’s favourite thing in the world. Well, maybe not. But it is one of the most important aspects of your financial planning, especially when it comes to your retirement fund. Depending on what kind of retirement account(s) you get, the application of taxes can vary. These factors could impact the total sum of money you are left with for manifesting your visions in retirement in really significant ways. More on that later.
Let’s first take a look at the basic mechanism of this tool for financial health that is what we know as the ‘retirement account’.
What is a “Retirement Account” anyway?
Just in case you’re not sure how retirement accounts work, it goes a little something like this:
Retirement accounts are created to save and grow money specifically for retirement.
A certain amount of money annually is deposited into the account.
That money is then taken by the wealth management company that is providing the account and invested into the stock market.
The growth that the account gains each year correlates to the average of how well the stock market did that respective year.
That’s the basic mechanics of ALL retirement accounts whether they are a 401K, 403B, or IRA.
There’s generally two types of retirement accounts. The kind that you get from your employer, or the kind you invest in yourself personally.
1. Retirement Account from your Employer
401K - This is the most common retirement account provided by employers. A portion from your paycheck is automatically deducted each time, and placed into a 401K.
403 B - This is the same thing as a 401K but from a not-for-profit organization.
*Note for Nurses/NPs/PAs: A lot of people in the Nursing industry have 403B’s because many healthcare institutions happen to also be non-profits.
2 Personal Retirement Account
IRA - A retirement account that you set up directly with a wealth management company. This means, the contributions to the account are made by you personally, without the intermediary of an employer.
At this stage of the article I would like to zoom our focus in to exploring more details around the dynamics of an IRA. Many people make the mistake of putting their retirement on auto-pilot, relying solely on the default retirement account that they can get from work. What people don’t realize is that when they do this, they are losing out on key opportunities that could increase the amount of money they can have access to in significant ways, when they retire. So.
What exactly is an IRA?
IRA stands for Individual Retirement Account. And is provided from wealth management companies (Like fidelity, Vanguard, Ameritrade, etc.) There are a wide variety of options when it comes to choosing an IRA.
Many of the accounts vary based on the level of risk you are comfortable with - which relates to the kinds of stocks that the company will invest in on your behalf. This aspect of the IRA is a bit outside of the scope of this article so we won’t go into detail about this. But if you have questions about this component, you can always contact us directly and set up a free conversation and we would be happy to help answer your questions
Taxes and the 2 different types of IRAs/401K’S
Ok, now we get to the juice. Remember earlier I said taxes, right? Watch where it comes into play.
There are 2 different types of IRAs: Traditional and Roth.
With a Traditional account, your money is tax deductible when contributing, and is taxed when you take it out.
With a Roth account, you’re using after-tax money to contribute but you are not taxed on it when you take the money out later on.
That is really the main difference. With some additional nuances of course, but that’s basically the meat of it.
How your money is affected depends on the tax rate the year it is deposited into your account(s), versus the rate the year it is taken out. Taxes will be deducted either way; however, the end amount you get to keep after tax deductions can vary enormously, depending on these factors.
Let’s take a look at each one of these 2 types of 401K/IRAs up close, and how to make smart decisions around which account to contribute to and when. That is, if you’re interested in maximizing your retirement fund..
1) Traditional (Pre-Tax) - Qualified
Think of this account as being qualified for tax deductions. Meaning that every contribution you make toward your Traditional 401K/IRA, is money you can deduct on your taxable income for that year.
Every 401K/IRA (Traditional and Roth) account has a cap on the max dollar amount of contributions that you can put in annually. The maximum/minimums in these accounts do also fluctuate depending on the type of account and over the years.
Today in 2020, for a Traditional 401k account you can contribute/deduct up to $19,500 a year max. IRA you can generally contribute up to $6,000.
A benefit of this type of plan is the fact that you can lower your taxable income. Which, in turn can affect how much taxes you end up paying in that given year.
For example, if you earn $100,000 and contribute all $19,000, you’re seen by the IRS as only making $81,000 and are taxed at that amount of money as your income. This can be a benefit especially if it means landing you in a lower tax bracket.
This strategy can similarly be beneficial if you needed to have less taxable income for other varying reasons. For example, this could mean a W2 employee gets a bigger tax refund, or a business owner/1099 owes less in taxes.
But remember, you still get taxed. It just happens later.
This means that when you pull your money out of your Traditional IRA/401K account during your retirement, you will be taxed at that time.
It is obviously more beneficial to you to be taxed on the money based on the more advantageous tax rate.
So generally, you want to put your money into a Traditional IRA when the tax rate is high during a given ‘contribution year’. We do this in hopes that the tax rate will be at a lower figure in our ‘distribution years’, i.e when you’re taking the money out. A ‘contribution year’ is when you put money into the account.
But what about if the tax rates are low in your contribution years? This is where the Roth account is exceptional.
2) Roth *Non-Qualified* (for tax deductions i.e. after-tax)
The Roth IRA/401K allows us to have an after-tax vehicle. Which means that the money goes into the account after you pay tax on it. Your contribution ends up being the amount that is left after taxes have been deducted. Which means that it is “non-qualified” for deductions when you are taking the money out in retirement.
This gives us a tax advantaged account because of the fact that it grows tax-deferred, and no matter how much growth you get, you’re not going to be taxed on the money again.
This can be a benefit in many ways!
One of the benefits is that the Roth IRA opens up a strategic vantage that allows us to make smarter financial decisions when tax rates are low.
This strategy also requires you to pay attention to catch the opportunities, if you wish to bank on them.
Contribute to your Roth retirement account when tax rates are low. This can make the difference of tens of thousands of dollars for your bottom line in retirement.
If tax rates are high, you can simply choose to not contribute into this account and go with your pre-taxed (traditional 401K. You want to take advantage at all times of lower tax rates to minimize the amount of money you’re giving away in taxes). Obviously there are also other accounts your money can go into, this is just an example.
This also allows financial planners to be able to construct a more consistent outcome of your future money because we know the taxes are already paid. Something we can never really predict.
Practically speaking If tax rates today are 37%, we have NO idea what they’ll be in 20-30 years from now. We can however construct a rate of return or an “average” of the prediction of your growth rate between now and retirement (however these will never be 100% accurate, as we cannot predict the stock market).
The biggest disadvantage of this account is that as of 2020 a person can ONLY contribute $6,000 a year to a ROTH IRA. Most people may want to invest more than this per year, and so these accounts are very limiting. This is also important to those contributing to a ROTH 401K because the contribution is a little less limiting, as of 2020 you can contribute $19,500 into this account.
This account also has restrictions on people making certain income levels (meaning if you make above a certain amount of money a year, you can sometimes not contribute at all or have to restrict your contributions).
In 2020, if you’re making less than $124,000 a year then contributing the max to a Roth is easy. If you’re making more than that as a single person, it could be more difficult. Speak to your financial advisor as there could be ways around this sometimes and also you can see what your income means specifically for your contribution
This is why taxes are so important in retirement or in any financial conversation. Minimizing the amount of money you’re paying in taxes for the next 30 years could be the most impactful financial decision of your life. It is best to minimize the amount of money you LOSE.
Note* This information also applies to 401K and 403Bs. You may not be aware that you can go either route of Traditional or Roth with the retirement accounts provided by your employer. But it is a choice that is usually available to most employees. If you don’t exercise this choice, it will default usually to being Traditional.
Other good to knows
Penalties & Early Retirement
“Retirement” is officially deemed no earlier than 59.5 years old. (“Early retirement” is anytime before this.) Note that these accounts are not built for early retirement, and you may be penalized heavily (generally 10%) if you take money out before you are 59.5 years old.
You obviously want to stay away from incurring any penalties on your hard-earned money. So I would recommend you become familiar with any restrictions enforced by your wealth management company.
Due to COVID some policies have changed so check with your employers if you are in a bad position financially due to current conditions. Some companies are waiving the penalty if you have had impact from COVID-19. Nurses automatically have this option because their work revolves around the healthcare industry.
Required Minimum Distribution a.k.a RMDs.
Be aware that the government requires a minimum distribution of your money at age 72. It used to be 70 until 2020 CARES act. So depending on the tax treatment of your account, you will be forced to draw some money from your IRA/401k/403B and perhaps even pay taxes on the money when you reach 72.
You might be interested to know however, that Roth IRA’s don’t experience RMDs.
The type of account you want to utilize for your retirement is heavily going to depend on your tax strategy. If you do not have a tax strategy, I would come up with one or talk to a professional. An accountant and financial planner can work together to get this done for you.
The simplest ways I can give advice here:
GENERALLY, if tax rates are low, you want to be contributing into an after-tax account as frequently as possible. If tax rates are high, you want to be contributing into pre-tax accounts as frequently as possible.
Right now tax rates are around 37% for the highest income earner, so take a look at the history of taxes to see where you may fall.
In my opinion, Under 40% is a good tax rate → contribute more to After-tax Accounts
In my opinion, over 40% is a bad tax rate → contribute more to Pre-tax accounts
If you would like to work out exact math, be sure to speak with a finance professional. Someone on our team would be happy to speak with you!