Traditional vs. Roth IRA and 401k Plans: Which Is Best for Your Future?
Holistic Financial Planning is about much more than rates of return. We look at your overall picture and how everything works together. For example, getting an 8% vs 10% return this year can be a secondary concern if you expose yourself to unnecessary taxation simply by not having your beneficiary forms filled out correctly in your retirement accounts. Or, if you don’t have an estate plan (will, power of attorney, healthcare powers), which can leave behind a mess for your loved ones.
During the savings years, money management is too often on a “set it and forget it” trajectory. However, there are many things that you should be paying attention to in order to set you up for the best future possible. Different buckets are taxed in different ways: Pre-tax (Traditional IRA or 401k), and Post-tax (Roth IRA and Roth 401k).
Pre-Tax (Traditional IRA or 401k)
With pre-tax investments, you get a tax break now on the amounts you’re contributing year after year. Your investments grow tax-deferred, but every cent you pull out in retirement is taxed at your income tax rate and the amounts you pull out can increase your tax rate, depending on your other income sources and the amount of your withdrawals.
Post-Tax (Roth IRA or Roth 401k)
With post-tax accounts, you do not get the tax break on the amounts you’re contributing every year. However, you will never pay tax on this money ever again (your contributions will always come out tax-free and as long as you have had a Roth IRA for at least five years and are over 59.5, the earnings will be tax free, as well).
I like to use a farming analogy to compare pre-tax and post-tax accounts: would you rather get the tax break on the seed (your annual contributions) or what it grows to in the future (the harvest)?
With a pre-tax account, you’re getting the tax break on the contributions, but the full harvest is taxable to you at your income tax rate when you start to pull it out in retirement, at whatever tax rates are at that time. You don’t really own the full amount, as everything withdrawn will be subject to taxation. With a post-tax account, you don’t get a tax break on the seed, but the full harvest is tax-free (assuming you satisfy the requirements listed previously). In a perfect world, all of your retirement assets would be in post-tax accounts, which is why having a strategy during the savings years, as opposed to “set it and forget it”, can make a huge difference in the future.
Roth 401Ks are becoming more popular in company-sponsored retirement accounts and most people have the ability to open and fund a Roth IRA. If you already have a large amount in pre-tax accounts you can utilize “Roth conversions” and convert all (or a portion) to a Roth IRA. Any amount you convert will be subject to income tax in the year of the conversion, so that’s something to be aware of. Often, we will look at converting a portion of pre-tax to a Roth every year, in order to help spread out the tax burden. It can be very beneficial for us to work with your CPA with strategies such as this to make sure everyone is on the same page and the tax burden is accounted for.
Every situation is different, which is why we don’t have “cookie-cutter” plans at Bailley Group Wealth Management. Everything is tailor-made specific to you and your situation. Utilizing Roth conversions may be extremely impactful to your situation, or it may not much difference at all, depending on other factors. Give us a call, we’d love to see how we can help.
*This is intended as general information and not specific tax advice. Please consult your tax advisor before making any changes.
