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Roth or Traditional: What works best for you?

Tuesday, July 19th, 2016

When making financial decisions, many times people make their choice based on what they heard is the right thing to do. This often times leads to the incorrect financial decision.

Whether it be investing your assets, refinancing your home, taking out a car loan, or choosing between a Roth and Traditional account, the best way to make a decision is by laying out all the numbers and letting them make the decision for you.

There is the continuous debate between which account, Roth or Traditional, will be best for your financial future. First it is important we understand what these accounts offer, and the differences between them.

Individual retirement accounts (IRAs) and 401ks are both retirement-saving vehicles. Roth and Traditional refers to the type of money that actually funds the account.

Through a traditional account you receive a tax deduction on your contributions. To make numbers simple, let’s assume you make $100,000 in a single year and you contribute $5,000 to your IRA. This now means you have a taxable base of $95,000.

The downside to this account is once in retirement, you pay income tax on the money you pull from it. It is also important to note, if you pull money from the account before the age of 59 ½, you are subject to a 10% penalty plus the income tax on the withdrawal.

Through a Roth, you fund the account with after-tax money. This means you do not receive a tax deduction on the contributions you make.

The benefit with this account is, once you start taking withdrawals, you pay no taxes. Another benefit you receive is since the account is funded with after tax money, if you need the funds before age 59 ½, only earnings on the account are applied to the 10% tax penalty. This means you can withdrawal your contributions anytime tax-free.

The biggest benefit you receive in both the Traditional and Roth accounts is your accounts grow tax-free. This means no capital gains tax along the way, like you see with ordinary investment accounts.

So now that you know the basics for these accounts, which one will work best for you?

The first question to ask yourself is, do you trust the government? There has been talk about the government taxing those Roth accounts, even though they were funded with after-tax money. For those saying this is not possible, Social Security was another source of income that was originally supposed to be tax-free.

The second thing to understand is the effect compounding has on the value of money.

Often times, people will look at tax rates and say if you are in the 25% tax bracket when you take the tax deduction, and the 33% tax bracket when you withdrawal the money, you should do the Roth.

The problem here is they are looking at stagnant money. Let’s assume you contribute $5,000 to a retirement account, make $100,000, file jointly, and live in the state of California. This means in a Roth account you would pay approximately $16,588 in federal taxes and $4,293 in state taxes. This brings you to a total tax bill of approximately $20,881.

Assuming the same situation, in a traditional retirement account with the $5,000 deduction, your federal taxes would be $15,338 and state taxes would total $3,983. This is a total tax bill of $19,321. This means the deduction saved you $1,560 in taxes for the year.

The reason we would rather take the deduction today and pay taxes in the future is due to the time value of money.

Simply put, a dollar today is worth more than a dollar tomorrow. The tax deduction’s value will compound and grow over the years to come.

Assuming an 8% average annual return for 20 years, that single tax deduction’s value will grow to a value of $6,733. This is just assuming the single tax deduction for that year, imagine the value if you receive that deduction for multiple years.

This means for the Roth to be advantageous, you would need to greatly increase your income while in retirement.

While the numbers say to take the tax deduction now, a Roth may still make sense in some cases. Building the foundation for a great retirement should be your main goal, but if you are greatly concerned about needing the money before 59 ½, the Roth may make more sense as the withdrawal penalty would be smaller.

You can mix and match Roth and Traditional contributions to an IRA, but the amount of contributions in a given year may not exceed $5,500 if you are under the age of 50, and $6,500 if you are over the age of 50.

You may also contribute to a work-sponsored 401k and an IRA, but limitations do apply.

Due to the complexities of the tax brackets and rules for contributions to retirement accounts, everyone has a unique situation.

The main goal of this article was to get you thinking about the numbers and how financial decisions could impact your overall wealth.  Be sure to consult with your tax professional to better understand these rules.

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