When saving for retirement, investors have plenty of choices, and tax strategy can be a big driver of the route they decide to take. Understanding the different tax implications of IRAs and 401(k)s is key to a good choice.
SEE ALSO: Why You Need a Roth IRA
First, some basics: Individual retirement acconts (IRAs) and 401(k)s are both retirement-saving vehicles. The terms Roth and traditional refer to the type of money that actually funds the account.
You can contribute to a 401(k) if your employer has set up this type of plan. They often have an option for Roth or traditional deferrals, but you would need to check with your employer on the rules. An IRA, either Roth or traditional, can be established at various banks or brokerage firms.
With a traditional type of account, you get a tax deduction on your contributions, as they are made on a pre-tax basis. To make numbers simple, let's assume you make $100,000 per year and you contribute $5,500 to your IRA. This now means you have a taxable base of $94,500.
The downside to this type of account is that once in retirement, you pay income tax on the money you pull from it. It is also important to note, if you pull money from the account before the age of 59½, you are subject to a 10% penalty plus the income tax on the withdrawal.
With a Roth, you fund the account with after-tax money. This means you do not receive a tax deduction on the contributions you make.
The benefit with this account is, once you turn 59½ and start taking withdrawals, you pay no taxes. Another benefit is that since the account is funded with after-tax money, if you need the funds before age 59½, you can withdraw your contributions tax-free and penalty-free. Only the earnings on the account would normally face the 10% penalty and taxes.
The biggest benefit to both the traditional and Roth accounts is that your accounts grow tax-free. This means no capital gains taxes to pay along the way, like you see with ordinary investment accounts.
Making a case for a traditional account
So, now that you know the basics for these accounts, which one will work best for you?
The first question to ask yourself is, do you trust the government? There has been talk about the government taxing Roth accounts, even though they were funded with after-tax money. For those saying this is not possible, Social Security was another source of income that was originally supposed to be tax-free.
The second thing to understand is the effect that compounding has on the value of money.
Often times, people will look at tax rates and say if you are in the 25% tax bracket when you take the tax deduction, and the 33% tax bracket when you withdrawal the money, you should do the Roth.
The problem here is they are looking at stagnant money. Let's assume you're married, make $100,000, file jointly, claim two personal exemptions and live in San Diego, and you decide to contribute $5,500 to a Roth IRA. This means you would pay approximately $11,095 in federal taxes, $7,650 in FICA taxes and $3,479 in state taxes. This brings you to a total tax bill of approximately $22,224.
Assuming the same situation, if you contribute $5,500 to a traditional IRA, your federal taxes would be $10,062, FICA taxes would be $7,650 and state taxes would total $3,039. This is a total tax bill of $20,751. This means the deduction saved you $1,473 in taxes for the year.
The reason we would rather take the deduction today and pay taxes in the future is due to the time value of money. Simply put, a dollar today is worth more than a dollar tomorrow, because of its earnings potential over time. The tax deduction's value, if invested well, will compound and grow over the years to come.
Assuming an 8% average annual return for 20 years, that single tax deduction's value will grow to a value of $6,865.59. This is just assuming the single tax deduction for that year, imagine the value if you receive that deduction for multiple years.
Making a case for a Roth account
While the numbers say to take the tax deduction now, a Roth may still make sense in some cases. Building the foundation for a great retirement should be your main goal, but if you are greatly concerned about needing the money before 59½, the Roth may make more sense as there are no penalties or taxes when you withdraw the money you contributed. Only the gains would face taxes and the 10% withdrawal penalty.
You can mix and match Roth and traditional contributions to an IRA, but the amount of contributions in a given year may not exceed $5,500 if you are under the age of 50, and $6,500 if you are 50 or older.
Based on your income level, you may also contribute to a work-sponsored 401(k) and an IRA, but limitations do apply.
Due to the complexities of the tax brackets and rules for contributions to retirement accounts, everyone has a unique situation. It is always important to consult with a qualified tax professional to evaluate your personal situation and how you can maximize those tax deductions.
Brent M. Wilsey, President of Wilsey Asset Management, is a highly regarded registered investment adviser and financial strategist with over 40 years of experience. He offers day-to-day investment guidance to both individual investors and corporations. Having opened his LPL branch office in 1992, currently Wilsey's firm manages over $200 million in assets. Reach him online at www.WilseyAssetManagement.com.
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