IRAs Roth or Traditional IRA or 401(k)? How to choose
WHICH IS BEST FOR YOU? Are you a big spender or a saver? Do you live paycheck to paycheck or make saving some of it a priority? Your answers could make some ways of saving far more effective for you than others. What shapes your financial personality? How much you know about investing is just one factor, according to Eric Gold, vice president of behavioral economics at Fidelity. For most people, spending, saving, and investing are a combination of their understanding of the topics and their emotional and psychological relationship with money. Some people micro manage their finances. They are organized, disciplined, and methodical about their money and are generally better about saving some of it, notes Gold. And they also value waiting for something rather than insisting on immediate gratification. Then there are their polar opposites. They are more impulsive, and place a greater value on enjoying their money in the here and now. Many of us are more impatient and want quick rewards, says Gold. How you feel about money is one way to help you choose between a Roth (after-tax) or traditional (pretax) IRA, 401(k), or 403(b). Future taxes and discipline The key thing to think about when choosing between a Roth or Traditional account is your tax rate today and what you think it will be in retirement. If you think your tax rate will be higher when you retire, an after-tax contribution to a Roth IRA or 401(k) may make sense. If you think your tax rate will be lower in retirement, a traditional IRA or 401(k) may be more appropriate. But, it is pretty hard to know what your tax rate will be especially if retirement is 20 years away. 1
But tax rates don t tell the whole story. How disciplined you are at saving can also play a role in which type of account may better help you prepare for retirement, says Matthew Kenigsberg, vice president of Financial Solutions at Fidelity. Here s why: Generally, contributions to a traditional IRA, 401(k), or other workplace savings account can help lower your taxable income (if certain requirements are met). For 401(k) contributions, the money is taken out of your paycheck before taxes are applied. With an IRA, you deduct your contribution on your tax return. This gives you more money in your pocket, but these tax savings can only help improve your retirement savings if you re disciplined enough to put them into your retirement account. If you get an income tax refund and go out and spend it, it s not going to help your bottom line, when you retire. With Roth contributions to an IRA or 401(k) you pay taxes on your contributions up front. That takes away from your disposable income or current paycheck, because more tax will be taken out. With a Roth 401(k) your contributions and your taxes are coming out of your paycheck each pay period. With a Roth IRA, your contributions come from after-tax savings. But, if you re like most people, who tend to spend what they earn anyway, having less disposable income might be a good thing when it comes to your retirement savings. You ve already paid your taxes, so you get to take your money out tax free,1 which could leave you more to spend in retirement. In a sense, says Kenigsberg, a Roth 401(k) forces you to save more for later by keeping less in your pocket now. 2
An example Consider this hypothetical example. While our example uses a traditional and Roth 401(k), the same principles apply to a traditional or Roth IRA. Meet three hypothetical investors Evan, Sara, and Cole. They all are 45, married, and plan to retire at 65. But, they are very different when it comes to their money. Evan is frugal and a relentless saver. His contributions to a traditional 401(k) come out of every paycheck. He tracks every penny, and if he has some money leftover at the end of the month, he invests all of it. Same goes for tax returns, bonuses, and any windfalls. Sara, like a lot of people, spends her paycheck. She also automatically contributes to a traditional 401(k), but when she gets a tax refund or has money left over from her paycheck, she doesn t save a penny. Instead, she goes out to dinner, takes vacations, and buys new clothes regularly. Sam has a lot in common with Sara. He ll spend his money if it is available on his debit card. He contributes to a Roth 401(k) at work. He likes the idea of not having to pay taxes on the money when he uses it for retirement. That said, let s run some numbers. They each have a $5,000 balance in their 401(k)s when they are 45 years old and plan to keep it in the account until 10 years after they retire, when they are age 75. That s a 30-year time horizon. Evan and Sara both receive a $1,400 tax refund because they made traditional 401(k) contributions. Cole doesn t receive a refund because his Roth 401(k) contribution doesn t reduce his taxable income. How much would they each have after 30 years, based on the type of 401(k) account they chose, and whether they saved or spent their tax refund? 3
A Roth 401(k): an easy way to save more? Our three savers are 45, plan to retire at 65, but have different lifestyles. Here s what their $5,000 401(k) contribution may be worth in 30 years. Saver or spender? Type of 401(k) Relentless saver Traditional pretax Tax refund Contribution value after 30 years $1,400 Invests the refund $35,445* Evan Shopaholic Traditional pretax $1,400 Spends on vacations $27,404 Sara Spends debit car money Roth, after tax No refund $38,061* Cole *After paying taxes at the time of withdrawal Marginal tax rate:28% (Assumed 2014 tax rate) Expected marginal income tax rate in retirement: 28% Hypothetical pretax return on investments: 7% Hypothetical after-tax return on investments: 6% 4
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