If there’s one thing most people know about retirement savings accounts, it’s that they come in a variety of “flavors.” Although the shorthand used by finance pros can muddy the waters, distinguishing them is pretty straightforward: as 401(k) or IRA, and traditional or Roth.
We discussed the difference between 401(k)s and IRAs in a previous Tip of the Week, so be sure to check out that one too if you missed it. Today we’ll look at the differences between Roth and traditional plans, which pretty much comes down to how they’re taxed.
So which is better? Well, as you can probably guess (drumroll please)… it depends. Two variables are important to consider:
- Your time horizon – that is, the number of years your savings will be able to grow before you start withdrawing from them for income.
- Your tax bracket – as far as you can tell, are you likely (or would you prefer) to be in a higher or lower tax bracket when you retire than you are now? Or will it be the same?
The tax bracket in particular is important. Suppose, for example, that you open an IRA at age 29 and funded it with $5,000 until age 65. Whether a Roth or traditional IRA gives you a better balance upon retirement depends in large part on whether or not you end up in a lower tax bracket after retirement.
We can draw two general principles out of this:
- If you have a long time horizon and you’ll be in the same tax bracket or higher in retirement, a Roth plan is probably better.
- If you have a short time horizon, or you expect to be in a lower tax bracket upon retirement, then traditional is probably better.
— Graham