When it comes to retirement accounts, decisions are personal and there is no one right answer for everyone in determining the lowest tax liabilities. Depending on your financial outlook and goals, there will be choices that benefit you more than others. What you need to do to decipher which is the best retirement account is to understand both and educate yourself before making an investment decision.
There are two very popular types of retirement accounts that most people are using to save for the “golden years.” They are the Roth IRA and the 401k accounts. There are some misunderstandings about the way these accounts can benefit account holders for retirement and how taxes are assessed with each.
Understanding the Roth IRA Account
The Roth IRA can be opened by anyone meeting the income guidelines and with financial institutions offering such services. Some consumers misunderstand the tax aspect of this type of account. The Roth IRA is not completely tax free. Essentially you pay the tax up front because the money you are adding to the account has already been taxed. As the money compounds over time, it will grow tax-free and provided the funds have been left in for the required time period of five years, they can be withdrawn tax free after the age 59 1/2 (with some exceptions to pull it out before without a penalty). The Roth IRA does not require you to take mandatory distributions. If you are looking to pass along money to your heirs, the Roth IRA may be the way to go. Otherwise, you can withdraw the money whenever you need to.
Understanding the 401k
A 401k account is an employee-sponsored retirement account. The contributions made to this type of account might also be matched by the employer. With the 401k, the rules are almost opposite of the Roth IRA. The money you are contributing to this kind of account has not been taxed or are pre-tax. The funds will grow tax free but when you take it out you will pay taxes on the contributions you have made to the account and whatever earnings the account has earned. At the age of 70 1/2, you must take distributions from your 401k account.
Which Is Better from a Tax Perspective?
Again, it all comes down to your personal financial situation and goals. A Roth IRA may be the way to go in order to avoid possible tax increases in the future if you expect your income to remain pretty stable or for it to increase after retirement. Taxes normally do not decrease and our personal income taxes comparatively to other nations are relatively low. It fact, it can be argued that since our government is building massive deficits, through massive spending, that tax rates will likely increase in the future (since spending cuts rarely come). Moreover, normally when you retire you may not get the tax deductions you did in the past. If you had a house and kids, then the deduction for interest paid on a mortgage or the deductions you lost with your children growing up may push you into a higher tax bracket then you were in before when considering a 401k.
If you think your retirement years will consist of considerable downsizing and more a more frugal lifestyle, the 401k may be ideal with a lower tax rate. Moreover, if your employer matches your 401k contributions, you may end up with more money than you would have otherwise even if taxes are increased (but no one knows). In some cases, those who are eligible for both account types may find that contributing to both kids of accounts may be the way to go.
However you decide to save for retirement, be sure to read up on all of the choices you have when it comes to saving for the future. Be sure to understand that not everyone can contribute to a Roth IRA as there are income limit restrictions depending on filing status. Moreover, contribution maximums differ by your age as well with both a Roth IRA and 401k.
Remember that the earlier you start planning for retirement, the more secure you will be when you finally reach retirement age. If you are overwhelmed by the information on retirement accounts, it is recommended you consult with a tax advisor who can highlight the pros and cons of each account type and analyze your specific financial situation.
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