In this article we will focus on some of the benefits of Roth accounts and these important points:
- Differences between Pre-tax and Post-tax savings
- Roth IRAs and 401(k) account contributions are made with post-tax dollars
- The difference between Roth IRAs and Roth 401(k)s
- Contribution and Income limits
- Required Minimum Distributions - RMDs
Post-Tax or Pre-Tax Savings
Concerning taxation, Roth IRAs (Individual Retirement Account) and Roth 401(k)s are treated from a tax perspective differently than traditional IRA and 401(k) accounts. With a traditional account, your contributions may be deducted from your taxable income or be contributed on a pre-tax basis, thereby giving you a tax break now. However, you will need to pay taxes on the withdrawals in retirement. The idea behind the traditional or pre-tax account was that you might be in a lower tax bracket when you retire and to incentive, plan participants to contribute to their retirement savings. With Roth accounts, it is the reverse; your contributions are made with post-tax dollars, so there is no tax break now. The big benefit is that you will not be required to pay taxes on your withdrawals in retirement, as long as you are at least 59 ½ and have had a Roth account open for five years or more.
At first glance, many people think that the traditional or pre-tax contribution may be more beneficial. They want the quick reward of tax savings now, or they may believe that they will be in a lower tax bracket in retirement. While Vestwell never gives tax or investment advice to any individual, we provide general educational information, that may help you make a decision about how to save in your retirement plan. You should always consider engaging a qualified financial professional to assist you when making any kind of decision about your investments.
Consider this: Your contributions will likely grow during your working years, as illustrated in the image below. In this example, the individual contributed $200 a month over 10, 20, 30, and 40 years. As you can see, if you contribute for 40 years, the principal or contributions total $96,000, and with a hypothetical compound interest rate of 7% over 40 years, it could accumulate to over $528,000!
So, What’s the Bottom Line?
Ask yourself, would you rather pay taxes on $96,000 now or $528,025 during retirement? If you answer that you would rather pay taxes on the seed instead of the harvest, then a Roth account might be the better option for you. We don’t know what will happen to tax brackets in the future, but even if you do land in a lower tax bracket, consider that a hypothetical rate of 20% tax on $96,000 is about $19,200 in tax, while paying tax on $528,025 at say a lower tax bracket of 15% would be about $79,200 in tax. The Roth would again prove to be a wise selection because you pay your taxes on the amount that goes in (the principal) and do not pay taxes on all the gains (earnings, interest, or dividends.)
Again, we’re not tax professionals, so the choice, of course, is yours to make, and the preferred option may depend on your tax bracket; it’s best to consult with an advisor to determine what is best for your situation.
You may contribute to both a Traditional IRA and a Roth IRA in the same year as long as you don’t contribute more than the annual IRA limit1. When this article was written in 2022, the limit was $6000, or $7000 for those age 50 and older.
Things to Keep in Mind
- It is essential to consider your timeline to retirement and when you plan to start taking distributions.
- You may generally contribute more to Roth 401(k)s than to Roth IRAs
- There are no income limits for Roth 401(k)s 1.
- RMDs are required from Roth 401(k)s, but not from Roth IRAs
- Non-working spouses may be able to contribute to a Roth IRA. Consult with a tax professional.
Roth IRA and 401(k) Differences
The below chart helps to illustrate most of the differences between Roth IRAs and Roth 401(k)s
Information for the Year 2023
If you would like to read more about the difference between Traditional and Roth accounts, you may read more in our article What is the Difference Between Pre-tax, Roth, and After-tax contributions.
1. There are income limits to contributing to a Roth IRA and a Traditional IRA's deductibility. Please see the IRS website for up-to-date information. The lower number of the “Phase Out” indicates the income where the contribution limits will start to be reduced for the contributor. The higher number represents the income limit, where the contributor may no longer make a Roth IRA contribution. Other factors may apply, please visit the IRS website for more detailed information. This article was written in 2021, IRS limits usually change annually.
2. Roth IRAs do not have RMDs for the account's original owner but may for some beneficiaries. Read more about RMDs in our article What is a Required Minimum Distribution or RMD?
3. Employer-sponsored retirement plans such as a Roth 401(k) may be rolled over into a Roth IRA. However, if you would like to roll over pre-tax dollars to a Roth IRA, it must go through a Roth conversion, which means you must pay any applicable taxes on the amount rollover to the Roth IRA.
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