April 10, 2014

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Article

Weighing the Costs

The Superior Retirement Account: Traditional or Roth?

By Lon Jefferies

April 10, 2014

$1,835

$1,619

Higher Tax Bracket in Future

On the other hand, if the investor was in the 15 percent tax bracket this year but expected to be in the 25 percent bracket during retirement (potentially a young employee expecting his earnings to rise), paying taxes now at 15 percent would allow $850 to be invested, which after 10 years of 8 percent growth would be worth $1,835 tax free.

Higher Tax Rate in the Future

 

Traditional

Roth

Initial Tax Bill (15%)

$0

$150

Invested Amount (after-tax)

$1,000

$850

Future Investment Value

$2,159

$1,835

Future Tax Bill (25%)

$540

$0

After-Tax Value in 10 Years

$1,619

$1,835

Roth Advantages

What if you expect to pay a comparable tax rate both now and in the future? A Roth account offers several advantages in this scenario. First, as taxes have already been paid on a Roth account, the government doesn’t require investors to take required minimum distributions (RMDs) from these accounts, whereas RMDs are required from traditional retirement accounts beginning at age 70½. Without RMDs, Roth accounts can grow tax free for the investor’s entire lifespan. Additionally, upon death, Roth accounts pass to an investor’s heirs without any tax liability, while those who inherit a traditional retirement account must pay taxes on the assets.

Second, money withdrawn from a traditional retirement account before the investor is 59½ may be subject to a 10 percent penalty. Yet contributed funds to a Roth account (but not the growth on the contributed funds) can be withdrawn at any time without penalty. While withdrawing funds before retirement isn’t advisable, the added liquidity of the Roth account can prove useful in emergencies.

Finally, even if your income is expected to remain constant, investing in a Roth account allows you to lock in your taxes at today’s rate as opposed to taking the risk that national tax rates might be raised in the future.

If you’re unsure how your future tax bracket will compare to your current rate, diversify. Nothing prevents you from having both a traditional and a Roth retirement account. This not only allows you to hedge your bets, but puts you in a position during retirement to take distributions from your tax-deferred account in low-income years and from the tax-free account in years when you are in a high tax bracket. 


Lon Jefferies is a fee-only certified financial planner with Net Worth Advisory Group.

 
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