When saving for retirement, the I.R.S. tax code allows many of us to choose one of two forms of tax qualification. Without delving too deep into who may or may not be eligible for either one, or in which type of retirement plan these qualifications belong, let’s explore the general attributes of each type.
Traditional tax-deferred saving in IRA’s and 401(k) plans has been around since the mid-1970’s. It has some tremendous benefits. This plan allows for tax deductibility (or pre-tax deferral) of dollars intended to fund one’s retirement. That means that a person can deduct their contributions into these plans from their taxable income. If Mary makes $60,000 and defers $6,000 into her corporate 401(k) in pre-tax contributions, then she only pays taxes on $54,000 of income.
Understand, however, that there is a trade Mary makes in order to get this deductibility of her contributions. As this is intended for retirement savings, the federal government imposes a 10% penalty (with a few notable exceptions) on any money that Mary takes out of this plan before she turns 59 ½ years old. Also, when Mary turns 72, she will be required to start taking money from the account whether she wants to or not. Most importantly, in this deal with the government, Mary is required to pay taxes on every cent that she pulls from the plan. Let’s elaborate with an example.
Remember that wonderful exemption that Mary got for contributing $6,000 to her qualified retirement plan? Over time, that $6,000 has accumulated interest and grown to $24,000. Because it has been in the plan, she did not pay taxes on her contribution or the growth of the investment. Mary turns 63 and decides to retire. She’s safely left that 59 ½ barrier behind, so no penalties are due. She decides to take that $24,000 out of the plan to supplement her income for the year. Guess what. The entire $24,000 is taxed as ordinary income that year. By deferring $6,000 and all the growth until she spends the money in retirement, Mary created a tax liability on $24,000 of income.
Mary doesn’t like that idea at all. She changes her mind, intending to wait and leave this account to her children after she dies. While she can defer taking money for a while, the government will more or less force her to start taking distributions shortly after her 72nd birthday. Those distributions are a percentage of the entire account balance and will increase every year based upon the I.R.S. mortality table. The federal government never intended for Mary’s retirement account to fund generational wealth. That’s why this rule exists. Retirement plans were designed to fund retirement and nothing else. Over time, Mary will be required to take more and more money from the plan and pay taxes on each and every distribution she receives.
In a nutshell, traditional tax-qualified savings plans are fantastic ways to defer income and achieve tax-deferred growth. They are not, however, the very best tools to save for any need before age 59 ½ or for generational wealth creation (inheritance).
The other type of tax-qualified retirement saving opportunity comes in the form of Roth contributions. This type of vehicle is quite a bit younger than traditional qualification, as it was created in the mid 90’s. Even though this strategy has been around for well over 20 years, it is still widely misunderstood.
Roth savings, like traditional deferrals, are a deal that is struck with the government regarding retirement. Both types are widely available in 401(k) plans as well as in personal IRA plans for those eligible. Both also feature similar restrictions on distributions before age 59 ½. Beyond those similarities, though, are many very important differences.
Let’s revisit Mary and her $6,000. This time, she saves her $6,000 in a Roth-style method. Unfortunately, by electing Roth contributions, Mary loses her ability to deduct the $6,000 from her income that year. She will pay taxes on that income for that year just like the rest of her earnings.
It’s in the next step that the Roth really shines. While in the account, the growth on that $6,000 isn’t taxed, and when the $6,000 grows to $24,000 Mary can take any or all of it out tax-free. By electing to pay taxes on $6,000, Mary is going to get $18,000 worth of growth with zero income taxes due when she retires at age 63.
Also, Roth IRA plans (rules are more complicated for 401(k)’s) don’t have a schedule for required distributions at age 72. Mary can wait until she’s 80 to take the first dollar from the plan if she wishes.
That makes Roth savings sound like a slam dunk! I mean, why wouldn’t you go for it with all the benefits it has? Like most things, yes, Roth savings has some definite advantages, but it has its drawbacks. Things like current income tax status, overall growth potential, time horizon for retirement, and many other factors have to be considered before a person can make the right choice between the two options.
Traditional-style deferred saving is a great retirement vehicle. Roth-style plans are a great retirement vehicle as well. Most Americans (subject to eligibility criteria) can use either or a combination of the two to fund their retirement. Which one is right for you? In general, Roth deferrals fit those of us that are currently in a friendly tax situation and those that are younger. Traditional methods become more and more appealing as one’s tax bracket increases and as a person ages. As with most things, everyone’s situation is different and those tools can be used in different ways for each of us. Once you understand how they work, you can formulate a good plan for using each tool in a way that best suits your situation.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.