By Lucas Caserez
Level Up Financial Planning
If you have earned income, then you are eligible to create a retirement account (or if your spouse has earned income). Your employer may even provide one in the form of a 401(k). If your employer doesn’t offer you a retirement plan, then you still have access to an IRA account.
That might seem simple enough, but where it starts to get complicated is determining whether you should choose Traditional contributions or ROTH contributions. (This article was inspired by a conversation I had on Twitter, thanks Michele!)
Traditional Contributions: 401(k)s & IRAs
- Most common
- Pre-tax contributions: Tax-deductible, which essentially reduces your taxes
- Growth: Tax-free
- You pay taxes when you withdraw at your future tax rates
- 10% Penalty to withdrawals made prior to age 59.5 (few qualified exemptions)
Roth Contributions: 401(k)s & IRAs
- After-tax contributions: which means you do not receive a tax reduction for contributions
- Growth: Tax-free
- Tax-free withdrawals!
- Contributions can be withdrawn without penalty
- 10% Penalty for withdrawals that exceed the contributed amount prior to age 59.5 (few qualified exemptions)
So which one is the best? That depends on where you expect your tax rates to be in the future when you begin to withdraw funds compared to your tax rates today,
If you expect your future tax bracket to be higher, then the Roth account would be more favorable to reduce your taxes overall. This tends to be the case for many people who are early in their career today with plenty of room to grow both in income and professionally.
Alternatively, if you expect your future tax bracket to be lower, then the Traditional accounts will allow you to reduce your taxes by the greatest amount. If you are a high-earner in the top tax brackets, but a low spender, you may benefit from reducing your tax rates now and creating a distribution strategy that allows you to control your future taxes.
What made sense previously may not make sense in 2020 and what you choose for 2020 might not be the best thing forever. Each year you should evaluate the Traditional Vs. Roth debate and make an intentional decision. I actually, love it when my clients have a mixture of Roth and Traditional investments because it allows for more advanced tax strategies when they retire.
Lucas Casarez is a husband, father of two amazing kids, and a Certified Financial Planner™. He founded Level Up Financial Planning, which is one of the few fee-only financial planners in Northern Colorado. The mission of Level Up Financial Planning is to guide his clients in taking their financial confidence to the next level.
Have a personal finance question you would like me to answer in a future week? E-mail email@example.com