11 Oct What is the Value of Each Dollar in Your Retirement Account?
The true value of the dollars in your retirement or investment accounts heavily depends on their location, namely what type of account it is and the tax structure of the account. You may think that a dollar is a dollar but the truth is that their values can vary significantly, sometimes up to a 50% difference, depending on whether the tax liability has been covered or not. The main point of this article is to discuss the two main account types Traditional and Roth and provide insight into when you should consider each.
The age-old question of “should I use a traditional account or a Roth”? The answer is: “it depends!” There are numerous factors to consider when deciding between contributing to a Traditional (pre-tax) account vs. Roth (After-tax) account and they all center on taxes. As a smart man once said,
“There are only two certainties in life: death and taxes” –Benjamin Franklin
Although our late founding father is correct in that everyone must pay taxes, there are ways to go about paying them in regard to retirement accounts that can optimize your retirement savings and add significant value to your investment portfolio.
The fact is, the dollars in various types of retirement accounts have different values. You can leverage each account type in order to optimize tax efficiency and diversification across your accounts.
Most retirement accounts are structured as traditional accounts to incentivize individuals to save NOW. These contributions are “Pre-tax” meaning they lower the individual’s tax bill for the year in which the contribution is made. These plans are great at lowering a person’s current tax liability and can provide the account with a larger initial contribution which will allow the account to grow faster. Another key to the traditional account is tax-deferred growth. The investor who owns a traditional account will not have to pay taxes on the dividends/interest received in this account or the capital gains as long as the funds remain in the account and are not withdrawn. However when the individual takes a withdrawal from their traditional account, they will be required to pay taxes on the withdrawals at their ordinary income tax rate. If taken before retirement age (59 ½ for most plans), withdrawals subject to penalty.
Many people explain that this type of account is the most effective since it provides an initial tax savings which will benefit the taxpayer in the year the contributions are made. Supporters also contend that when the individual takes withdrawals in retirement they will most likely be in a lower tax bracket since they no longer are working.
A growing retirement savings vehicle is the Roth. The Roth IRA was introduced in 1997 named after Delaware senator William Roth and the Roth 401(k) entered the retirement community in 2006. Contributions for the Roth IRA/401(k) are made with after-tax dollars. The dollars deposited in the account will still receive the tax-deferred growth benefit but the primary advantage is that when you take withdrawals in retirement, or after the age of 59 ½, the withdrawals are TAX-FREE. This benefit cannot be overstated. If you have a $1,000,000 Roth Account, it is truly worth $1,000,000 as compared to the traditional account which will face ordinary income taxes when funds are withdrawn.
Roth accounts are growing in popularity as seen by the increase in Roth IRA assets from approximately $232 billion in 20071 to $660 billion in 20162. Experts will say this account may be better for younger savers who are currently in a lower marginal tax bracket and plan to be in a higher one as they gain experience and see increases in their pay. Additionally, these younger workers have a longer time period so their after-tax contributions can grow for years and qualified withdrawals will be tax-free. This is not to say that the worker in their 40s and 50s should not contribute to a Roth but it simply depends on the individual’s current and expected future marginal tax brackets on whether it makes sense to contribute to a Roth over a Traditional.
MyRoboAdviser’s Take on Traditional vs. Roth:
Utilizing both Traditional and Roth IRA account types provides tax diversification and flexibility. You’re able to leverage your withdrawals to fully take advantage of your marginal tax rate. You will also have the capability to change your withdrawal patterns to adjust to your retirement expense needs. In years you have larger or unexpected expenses you are able to take those withdrawals from your Roth and not have to potentially move into a higher marginal tax bracket which could be the result if you take significant amounts from a traditional account. An additional reason to contribute to both Traditional and Roth accounts is because the future is unknown. We are unaware of what the future tax rates will be decades down the road. Thus it can be in your interest to benefit from tax savings in the present (Traditional) as well as utilize a future tax-savings vehicle with the Roth. In conclusion, contributing to either a Traditional or Roth retirement account is a step in the right direction. Further analysis is needed based upon each individual’s specific tax situation in order to determine which account is best.
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Last updated, October 9, 2018
1 Investment Company Institute: The IRA Investor Profile: Roth IRA Investor’s Activity, 2007-2012
2Investment Company Institute 2017 Ten Important Facts About Roth IRAs
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