There are many wonderful reasons to invest in a post-tax retirement account such as a Roth IRA. But tax-deferred retirement savings vehicles such as traditional 401(k)s and IRAs that let you put money aside before Uncle Sam gets his share deserve a serious look too. Here are several advantages of saving in a pre-tax retirement account you should take into account before you decide that a Roth IRA is right for you:
There are more obstacles to withdrawing money early. Just because you save doesn't mean you are home free because you can often find an excuse to use the money you've accumulated. When assets are in tax-deferred accounts, there are often penalties involved if you ever need to get the money out.
Even if you comb the details of the law and find a way to withdraw your money penalty-free, you still have to pay a good chunk of taxes on your withdrawal. In a world where temptation is everywhere, these obstacles may help motivate you to leave your money in the account until retirement and turn out to be what your future self appreciates the most.
You can deduct the contributions automatically from your paycheck. Until the Roth 401(k) becomes more popular among employers that offer 401(k)s, the easiest way for most employees to save for retirement is through payroll deductions toward a traditional 401(k). By paying yourself first you don't have a chance to forget about the contributions, nor can you actually spend it because you won't ever touch that money. Having the contribution automatically invested instead of manually hitting send seems like a small convenience, but it's amazing how much of a difference this simple adjustment can make. Try it, because it works.
Another advantage of having money in a 401(k) is that your assets are better protected. It's just harder for creditors and lawyers to go after assets in your 401(k), so use that to your advantage.
You can move to a lower tax state before you withdraw the money. A seldom talked about strategy when deferring taxes is to move to a no income tax state by the time you retire and have to withdraw from your portfolio. This way, you might be able to skip paying state taxes on your retirement account withdrawals. Moving is a huge decision that involves much more than just the state tax rate, but the option is at least available for those who choose the tax-deferred route.
A Roth IRA conversion is possible during low income years. This maneuver requires careful consideration, so work with a competent accountant who is familiar with the procedure. If you do this correctly, you may be able to avoid paying taxes on your contributions all together in some cases.
Roth IRA conversions are taxed at ordinary tax rates, so you can choose to convert part of your tax-deferred assets in years when your income is low to avoid paying a high tax rate. If you have no other income for the year, part of your conversion will even be converted to a Roth tax free. Next time your income drops, remember to look into this because it could significantly boost your nest egg.
You could pay a lower tax rate in retirement. You avoid paying the top marginal tax rate on every dollar of your contributions to a pre-tax account, but not every dollar of your withdrawals will be taxed at the top rate. Thanks to the progressive tax system, the lower range of income is taxed at a lower rate, and the tax rate moves up as your income increases. That means a portion of your withdrawals will be taxed at the lowest rate, while part of it will be taxed at a higher rate. On the other hand, contributions would have been taxed at your top rate, so don't just try to compare your tax rate during your retirement and working life to determine whether you should choose a tax-deferred account.
David Ning runs MoneyNing, a personal finance site that shares money moves you can make to significantly increase your chances of having a comfortable retirement. He likes to share simple changes that anyone can make, such as picking the best online savings account and figuring out whether a 0 percent balance transfer credit card makes sense.
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