Saving for retirement is important for all of us and our clients. Some clients know all about their retirement options and others do not. There is often particular confusion about Roth IRAs and Roth 401(k)s and how they differ from their traditional counterparts.
With traditional IRAs and 401(k)s, the contributions to the accounts are deductible when made. The money in those accounts builds tax-deferred. For example, let’s say you contribute $5,000 to an IRA. You can deduct that $5,000 from your income for the year. Let’s say you invest that $5,000 into XYZ company stock (held in the IRA). The stock pays dividends of $100 each year (held in the IRA). After two years, you sell the XYZ company stock for $10,000 and invest it in CDs which pay interest of $300 each year (inside the IRA). These dividends and the sale of the stock are not taxed. The account continues to build. However, when you start making withdrawals, those withdrawals are taxed as ordinary income. Some of the increase in the account was due to ordinary interest income, some was due to dividends, and some was due to capital gains. However, when there is a distribution from a traditional IRA or 401(k), it’s always taxed as ordinary income.
On the other hand, contributions to a Roth IRA or a Roth 401(k) are not deductible when made. After the account exists for a few years, the distributions from the account are tax-free. Here is the critical difference between a traditional and a Roth account. A traditional account builds tax-deferred while a Roth account builds tax-free. Let’s assume the account was invested as in the first situation. Not only do the dividends, capital gains, and interest earned in the account build tax-free, when distributions are eventually made, they come out tax-free.
Thus, the decision regarding whether to contribute to a traditional or Roth account depends in part on your current tax bracket and the one you assume you’ll be in when you start making withdrawals. If you are currently in a very low income tax bracket, the Roth may be a no-brainer.
In my next blog, I’ll discuss converting from a traditional IRA to a Roth IRA and the possible advantages of doing so.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (800) 846-1555