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In our last post, we talked about two different types of Individual Retirement Accounts (“IRA”) and 401(k)s: the “Roth” and the “Traditional.”
A Roth retirement account essentially means that you pay your taxes now to save on taxes later.
A Traditional retirement account essentially means you save on taxes now, but pay your taxes later.
This small flip of when you pay taxes can have huge implications, and your choice can save or cost you tons of cents.
Let’s use Mr. CentsAndSense.com as an example. If Mr. CentsAndSense.com currently has a 20% tax rate, and believes he will have a 35% tax rate, he will save $3,250 by paying his taxes now ($5,250 – $2,000).
|Tax Bill Chart||20% Bracket Now||35% Bracket Later|
If Mr. CentsAndSense.com currently has a 35% tax rate, and believes he will have a 20% tax rate, he will save $500 by paying his taxes later ($3,500 – $3,000).
|Tax Bill Chart||35% Bracket Now||20% Bracket Later|
Obviously this example is simplified, and there are other considerations that can influence whether or not you should open a Roth or Traditional retirement account.
These considerations may include:
- Future tax rate expectations – most people only expect tax rates to go up, especially if you become one of the wealthy, which I know you all will (hopefully with the help of this blog!). If you think government taxes will go down, or your earnings will go down, you probably want a Traditional more than a Roth.
- Future investment return expectations – if you think you will do super well, then you will probably lean more towards paying your taxes now and probably want a Roth more than a Traditional.
- Ability to save more pre-tax or post-tax – if you saved money on taxes, would you invest all of it in your retirement account (this probably means you’re not maxing your IRA and 401(k)) then a Traditional retirement account might work better for you. If you want to maximize the tax benefits of saving for your retirement, then you probably want to think more about Roth accounts.
- Age – If you are closer to retirement, that may mean you are at the peak of your earnings potential, and thus may benefit from paying taxes later. If you are young, that may mean you still have a way to go to increase your earnings, and thus it might make more sense to pay your taxes now.
A third option is to put money in both types of accounts – just make sure to track how much you’re putting in so you don’t exceed the IRS limits for contributions to tax-free retirement accounts.
Personally, I’m partial to maximizing my Roth, because I’m young, and I hope to keep making more and more cents as I age.
Do you prefer a Roth or Regular retirement account?
If your salary is super high and can preclude you from opening up a Roth IRA account, visit this page for two potential options.
Click here to learn more about why you should be saving for retirement now.