Updated 2/15/2022
With the 2022 tax season now underway, it is important for investors to understand the relationship between taxes and their investments. Whether you are opening an Individual Retirement Account (IRA) or participating in an employer’s 401(k), most investors will have the option between two main contribution types: Traditional and Roth. While the decision can seem obvious at times, it may not be as cut-and-dry as you think.
Traditional contributions, also known as pre-tax contributions, are those in which salary deferrals enter your retirement account without taxes being taken out. When you withdraw from your retirement account in the future, however, you will then pay the taxes at that time.
Roth contributions, also known as post-tax contributions, are the exact opposite. While your salary deferrals have the taxes taken out today, any withdrawals that you make in the future will be tax-free, since the taxes were paid upfront. In short, traditional contributions pay the taxes later, while Roth contributions pay the taxes today.
When deciding which type of contributions to make, the main factors to consider are your future earning potential and future tax rates. Those who are currently mid-career or experiencing their highest earnings may want to consider traditional contributions, as their tax rate near the end of their career may be considerably lower than their current tax rate.
Likewise, if you believe taxes will be lower in the future in general, traditional contributions may be the better choice. On the flip side, if you believe that you will be making significantly more in the future, it may be better to do Roth contributions so that you are paying taxes at your current, lower tax rate. Also, if you think tax rates may rise in the future, Roth contributions would be the better option.
While future earning potential and future tax rates are the main determinants for what type of contributions to make, there are some caveats. For example, if by some miracle your tax rate remains the same during your working years and after you retire, there is no difference between choosing traditional versus Roth. Also, it is impossible to truly know how the future will be regarding your earning potential and tax rates.
While it is a safe bet for younger people to assume that they will earn more in the future, it is not a given. Likewise, it is impossible to know how legislators will affect tax rates in the near and distant future, so there is a bit of guesswork involved there as well. However, investors should be able to make an educated guess based on these two aspects in an attempt to be more tax efficient regarding their retirement.
