As young Americans try to save for retirement and a financially secure future, one question that often arises is whether it is better to save pre-tax in a traditional IRA or 401(k) vs. saving after-tax in a Roth account. Depending on the situation, an individual may have access to Roth accounts in their 401(k) or outside of the plan in a Roth IRA. The rules around Roth 401(k)s and Roth IRAs are a bit different, but both offer the ability for tax-free investment returns if certain requirements are met.
The general rule of thumb for young savers is to save in a Roth account as opposed to a pre-tax IRA or 401(k). The basis for this rule of thumb is pretty straightforward: Young savers should pick Roth savings because their incomes, and therefore their tax rates, are lower today than they can expect them to be in the future. So, they would be paying the taxes on the Roth money upfront, at a potentially lower tax rate. With traditional IRAs and 401(k)s on the other hand, you avoid paying taxes now, but when it comes time to take money out in retirement, every dollar you take is taxed, and it could very well be at a higher rate.
So, from a wealth-accumulation standpoint, it is better for young people to save after-tax in a Roth account because if you don’t pay a lot in taxes today, you also don’t benefit much from any tax deductions you would get by contributing to a traditional IRA or 401(k).
The tax benefit comparison between a pre-tax savings and Roth savings is typically the main factor for choosing between the two options. But while the general rule of thumb supports younger investors utilizing Roth savings, there are a number of factors that instead support pre-tax savings that often go underappreciated.
Pre-Tax Savings for a Deduction May Be Smart for Those in Debt
While young savers can benefit from the tax-free growth aspect of Roth accounts, they are often struggling to meet their daily expenses. This makes saving for the future incredibly challenging. So, for many young savers almost living paycheck to paycheck, even $100 or $200 of additional tax savings this year through a traditional pre-tax deductible savings might seem worth it, even if that means giving up thousands of dollars in future retirement savings that a Roth might provide. This is especially true if a young person has credit card or other high-interest debt, where a few hundred dollars of additional debt payment could be the better financial move.
Saving tax-deferred and receiving a few hundred dollars in tax benefits upfront can be utilized to pay off high-interest debt, which might be better than saving in a Roth. A tax deduction or increased refund this year can be used by many young borrowers to reduce debt, as opposed to waiting for the tax benefits of a Roth that won’t be realized until retirement.
Pre-Tax Savings Could Be More of a Sure Thing
Public policy risk is also all too real and can provide another argument in favor of using a pre-tax savings over a Roth account today. For a 25-year-old who already might believe that Social Security will be cut or gone by the time he or she retires, it may be hard to believe that the government will keep the current tax law on Roth accounts stable for the next 40 years. Roth accounts offer tax-deferred and tax-free investment growth for retirement, but pre-tax savings offers an immediate tax deduction against this year’s taxable income.
With the current political environment, potential for tax reform, growing debt and the fact that changes to Roth account taxation have been proposed in Washington over the past few years, it would be unreasonable to ignore this risk. Taxation of Roth accounts, especially Roth IRAs, could occur in the future as a way to help reduce budget deficits.
It is not impossible that a young person today who uses a Roth account as a savings vehicle will see substantially different tax laws when he or she is ready to use the Roth money in retirement. Utilizing a traditional pre-tax salary deferral provides a guaranteed immediate benefit, while a Roth account provides an uncertain future benefit. It is not altogether unreasonable to take the secure, guaranteed benefit over an uncertain and riskier future benefit.
A Pre-Tax IRA or 401(k) Is Tougher to Tap Early
Traditional IRAs, 401(k)s and Roth IRAs were all designed to be utilized for retirement savings. However, traditional IRAs and 401(k)s have been set up in a manner to encourage savers to leave their savings alone, while Roth IRAs do not have the same mechanisms for discouraging early withdrawals. Traditional IRA contributions that are withdrawn prior to age 59½ are generally subject to ordinary income tax and an additional 10% tax called the 72(t) early withdrawal penalty tax. However, Roth IRA contributions are not subject to the penalty tax, meaning that your contributions can be more easily withdrawn and spent before retirement. This is often cited as a benefit of Roth IRAs, although it can backfire with young savers as they have more access to their funds and will be more likely to spend them on other expenses. This could lead to less money being saved for retirement if the funds are withdrawn early from the Roth IRA.
Young savers need to balance their current spending with long-term retirement goals. This means saving early and leaving the money alone to grow over time. Roth IRAs could be the best savings vehicle for many young savers, but the decision of where to save can be complex. Roth IRAs are still a great savings vehicle for young individuals as Roth savings can provide tax diversification and spending flexibility. Roth savings can have downsides, though, especially when it comes to behavioral aspects of savings and spending:
- Roth IRAs might allow too much access to contributions.
- In addition, because the true tax benefits of a Roth accounts for a young individual is subject to a degree of uncertainty, it can be hard to quantify — unlike a traditional IRA, which can offer a very clear economic tax benefit today.
The Bottom Line: Save in BOTH Traditional and Roth Accounts
In the end, it is important to remember that saving in either a traditional pre-tax account or Roth account provides significant benefits to the saver, and both types of accounts can be extremely valuable savings vehicles for retirement. Don’t fall into indecision by analysis paralysis. Instead, utilize both savings vehicles. That strategy lets you diversify the tax treatment of the money you put aside for retirement through both tax-deferred traditional and after-tax Roth savings.
This article provided by NewsEdge.