A further complication of IRA and (some) 401(k) accounts is that they actually come in two different varieties, Roth and traditional. Not all employers offer a Roth 401(k) (if yours does not, do not worry about it).
The basic difference between IRAs is that with a traditional account, contributions are pre-tax (or tax-deductible) and withdrawals are taxed at the income rate. With a Roth account, contributions are made after tax, but withdrawals are tax-free.
Much ink has been shed debating the relative merits of Roth and traditional accounts, but for most people, the differences in the two types of accounts are quite negligible compared to the huge benefits in fully using either one of them. In fact, traditional and Roth accounts will produce a mathematically equivalent income in retirement for many people under many scenarios. This is because the primary difference between the two accounts is one of timing; with a Roth account, you pay taxes now but save money on taxes later, whereas with a traditional account you receive tax savings now but have to pay taxes later.
- If you expect to be in a lower tax bracket in retirement than you are now, then a traditional account might be the best choice since it makes sense to take your tax deduction now, when it is worth more. This may be the case if you have only modest retirement savings and expect your retirement income to be much lower than your current income.
- If you expect to be in a higher tax bracket in retirement than you are now, then a Roth account might be for you. This may be the case if you have large retirement savings or if you receive a significant inheritance, for example.
- If you expect to be in a similar tax bracket but are worried that taxes will increase in the future in order to pay down large government deficits, a Roth account might be your best choice.
- If you are already “maxing out” the contributions to your retirement accounts and would like to be able to contribute more, then a Roth account might be your best choice. This is because you are contributing after-tax dollars to the Roth, so the effective contribution limit is greater.
- For IRA accounts, a Roth provides greater flexibility in the timing of withdrawals, which can be an important feature if you anticipate needing to access your funds prior to retirement or if you want to leave money to heirs. Roth accounts allow you to withdraw contributions (but not investment gains) at any time, they let you withdraw up to $10,000 for a first-time house at any time, and they let you refrain from ever taking withdrawals.
Table 4 summarizes the primary attributes of these most common types of retirement accounts