There are few guarantees in life, but paying income tax is something you can always count on. When and how you pay taxes plays an important factor as you consider different accounts to use to fund your retirement. Do you want to pay taxes now and be done with them? Or would you rather put off paying taxes as long as possible? Is a Roth IRA or a 401k a better option for your retirement?
Income Tax and Your Retirement
There are two schools of thought when it comes the impact of paying taxes on your retirement. One argument is that the federal government will be forced to increase the personal income tax rate eventually. If you had the option of paying a lower rate today than you would be charged in the future, it makes sense to pay the tax today. There are many contributing factors seen for an eventual tax inrease: the large deficits traditionally run by Congress, the impact of baby boomers on the social net that provides services such as Social Security and Medicare, and a smaller population of workers to pay taxes into the system to fund the running of the government. Additionally, regardless of income tax rates in the future, if you pay tax today you never pay again. The total in your nest egg is the actual total – you don’t have to calculate how much will come out for taxes.
The other school of thought is to delay paying taxes as long as you are legally allowed to do so. If you do not pay tax when you first invest your money, you have a larger pool of money to invest. The more you put back into the retirement account, the more compound growth you will enjoy. Some also believe that instead of the personal income tax increasing that the entire tax code will be revamped in the future. These individuals decide to take the known tax break today over the unknown tax rate in the future. You end up “losing” if you pay a higher tax rate today than you would in the future, so they decide to wait it out to see what changes come.
Pay Taxes Now: Your Retirement Options
If you want to pay taxes now in hopes that today’s tax rate will be lower than what you could pay in the future, you have two main options: a Roth IRA and a Roth 401k.
A Roth IRA can be opened with many discount brokerage firms or at your favorite bank. Since you pick where you open the account, you seemingly have more control over your investment options. You are limited to contributing $5,000 in after-tax dollars per year toward retirement within the Roth IRA, and your income must be below specific levels determined by your tax filing status. Singles with a modified adjusted gross income below $109,000 and married filing joint with a modified adjusted gross income below $169,000 can fully contribute. Additionally those that meet the income requirements and are over age 50 may contribute an additional $1,000 per year toward their retirement.
A Roth 401k is a relatively new option to the retirement arena. Similar to a Traditional 401k, a Roth 401k is tied to an employer-sponsored retirement plan. A Roth 401k is simply a 401k that is funded with after-tax dollars. The same limits that apply to a Traditional 401k apply; you are limited to contributing $16,500 per year toward retirement ($22,000 if you are over age 50).
Pay Taxes Later: Your Retirement Options
If you want to defer taxes until retirement in hopes that your income tax rate will be lower in the future, you have several potential options. You must also be aware that the current laws force you to begin taking distributions from the accounts in retirement (usually at age 70 and ½) so that you will be forced to eventually pay the income tax on the money.
Traditional 401k and 403b
A 401k and a 403b are both employer-sponsored retirement plans. The 401k is the most familiar option as these accounts are the most widely offered retirement option by employeres. Alternatively employees working for 503c non-profit organizations, public education employees, and select other organizations participate in a 403b. With these accounts your retirement is tied to your workplace, and your employer decides what your investment options are. You may contribute up to $16,500 per year toward retirement. Employees over age 50 are allowed a “catch up” contribution of an additional $5,000 to bring the total annual contribution limit to $22,500. Many employers also match a percentage of an employee’s contribution to their retirement account.
A Traditional IRA is very similar to a Roth IRA, with the primary difference being that you pay taxes in the future on the Traditional IRA while enjoying a tax deduction today. You can contribute up to $5,000 of pre-tax dollars (and an additional $1,000 if you are over the age of 50) toward your retirement. These accounts can be opened at most discount brokerage firms or banking institutions.