Mo Money's Building Wealth Blog

Should I be putting my money into a 401K\Traditional IRA or a Roth IRA for retirement?

Firstly, congratulations on being interested in saving for your retirement.  Secondly, let’s assume that your income or 401K plan doesn’t limit you from contributing to either, and let’s look at a high-level contribution summary of each to understand what makes them unique-

401K\Traditional IRA

• You contribute pre-tax dollars, and they compound over time, tax free until you withdraw them (hopefully after age 59 ½) at which time they are taxed at whatever tax bracket you happen to be in.  So, you “defer” the tax on your original contribution and take advantage of the compounding gains over time.
• You are allowed to deduct any yearly contributions from your taxes, so it effectively reduces your income for tax reporting purposes and thus the amount of taxes you pay, dependent upon your tax rate.  For example, if a single person in the 24% tax bracket contributes $5,000 over the year, then they would be allowed to take a $5,000 deduction on their taxes at year end.  This results in $1,200 more cash in your pocket as 5,000 x .24 = $1,200. 

Roth IRA (note: some 401K plans offer this option too)

• You contribute after-tax dollars, and they compound over time, forever tax free.  Because you contribute after-tax dollars, at time of withdrawal (hopefully after age 59 ½) none of the principal or gains that compounded over time will be taxed. 

Ok, so which is better? 

There is much debate, but conventional wisdom seems to be that a 401K\Traditional IRA is a better bet if you expect to be in a lower tax bracket when you withdraw the funds, and a Roth IRA is a better bet if you expect to be in a higher tax bracket when you withdraw the funds.  Also to consider is   whether you are looking for a tax break now (Traditional) or in the future (Roth).  I would go one step further and say that if you are a savvy investor and expect your contributions to grow exponentially then a Roth would seem to be a better choice.  Imagine for a moment if you had invested your Roth funds in Amazon or Nvidia years ago?  You’d have tens of millions of tax-free gains today from a proportionately small investment.

What do I think the better choice is?

The best choice is really what works best for you based on your current budget (i.e. do you possibly need the tax savings now) and where you predict you’ll be financially, in retirement.  Personally, I like to have a combination of both types of instruments in my retirement portfolio.  I guess you could call it hedging my bets.  In fact, I put my retirement savings into 3 distinct buckets:

1. Taxable at time of withdrawal (401Ks, Traditional IRAs)
   1. Most of my mutual funds are in here as I expect to retire in a lower tax bracket
2. Non-Taxable at time of withdrawal (Roth IRAs)
   1. I try to keep my riskier investments here – those that pay a higher percentage of dividends and have a higher growth potential, especially individual stocks.
3. Taxable yearly (Savings and Brokerage Accounts)
   1. The interest and any capital gains being taxable every year, I keep my lower interest rate stuff here – like an emergency fund, cash, CDs, and bonds.

By using a 3-bucket strategy I can take from any of the buckets in any given year in such a way that I minimize my overall tax burden for that year.  Putting it another way I try and keep myself in the lowest tax bracket possible and defer paying taxes as long as possible. 

Note:  This post is meant to be a high-level summary and education.  It is not to meant to cover every nuance of retirement savings.  It should be noted that both contributions and tax deductions for 401Ks and IRAs could be more limited at higher salary levels and whether you already contribute to a company 401K.  Also, some 401K plans allow both Traditional and Roth type contributions within the plan.  Unfortunately, my company didn’t offer a Roth option.  Talk to your company about options.  Either way, do some thorough research prior to developing your own strategy and consult with a financial planner if needed.  This is some important stuff if you want to secure a robust retirement.

Please feel free to comment and offer tips on your own personal strategy.