When it comes to retirement accounts, there are two basic types – Pre-tax (also known as Traditional) and Roth. It can be confusing and overwhelming to select the right choice. To start, let’s simply break down the difference between the two.
Pre-tax retirement accounts allow participants to contribute to the accounts on a pre-tax basis, just like the title states. As an example, let’s assume that the participant earns a $50,000 salary. They contribute 10% (or $5,000) to the retirement plan for the year. On their tax return, their income will show $45,000. That’s how the tax deduction comes into effect. The downside is that any distribution taken from the account will be included as taxable income the year that the distribution is taken. If the distribution is taken prior to age 59 and ½, there’s an additional 10% tax penalty tacked on. No fun!
Roth retirement accounts are the exact opposite of what’s described above. When contributions are made into a Roth account, there are no special tax incentives or tax savings. However, the contributions and the earnings on the account can be tax-free income when distributed down the road. As long as the account has been open for 5 years, and if the distributions are taken after age 59 and ½, the distributions are tax-free. The Roth can be an incredible tool, especially for younger savers.
The decision on pre-tax or Roth can be a tricky one. If current tax savings is the ultimate goal, then pre-tax contributions may be best for your situation. If long-term flexibility is the goal, then Roth contributions may be a better alternative. Either way, building the long-term savings habit is most important. Make sure to consult with your tax and financial advisor to make the best decision for you!