With the traditional version, contributions reduce taxable income and the current tax bill, but future distributions will be taxable. If both versions are available, which should you choose for contributions?
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Employees in relatively low tax brackets may prefer the Roth k because the current tax savings will be modest and the advantage of tax-free withdrawals in retirement may be significant. Employees in higher brackets may opt for the traditional k for upfront tax reduction.
On the other hand, even plan participants with high income might choose the Roth side if they wish to have a source of tax-free cash flow in retirement and they already have ample pretax funds in the traditional k. That could be a savvy selection, but you should consider the alternatives.
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Instead of maxing your k , you may prefer to pay down any credit card balances. The choice between unmatched k contributions and paying down a home mortgage or student loans is a tougher call. Mortgage interest usually is tax deductible, and student loan interest might be, as well. Jill believes she could earn more than that in her k , so she increases her contributions to her k at year-end and raises her contributions for , rather than planning on sending extra amounts to reduce her mortgage balance.
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If her company does not offer a Roth k , Jill may have to make another choice. As is the case with a Roth k , Roth IRAs are funded with after-tax dollars but may deliver untaxed cash flow in the future. IRA owners also have some year-end tax planning opportunities. Additionally, when you state that your Roth k balances are equal for you and your employer match, do you realize that your employer is only matching your POST TAX contributions?
I hope this point finally makes it through to you as your article in its current state is misleading and wrong.
In the end the SAME exact amount of money is going into a traditional or roth k. Same investments and same growth will equal the SAME exact balance.
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The only difference is when it comes to contributions, how much money you take home. So no free lunch. Money you put into a Roth k is post tax money. Whoops, I mixed up the pre-tax account and the after tax account. It should be the pre-tax Traditional and after tax Roth. But the point is still the same, it appears you fail to account for taxation on the Roth contribution.
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Thanks for the clarification. Let me restate it another way. One of the interesting nuances of a k retirement account is how it effects your effective tax rate. The standard progressive tax structure the US uses, giving a much lower effective tax rate than a Roth. It makes a lot of sense — I just need to figure out a way to pencil it out and see the true savings.
A traditional k defers taxes of the amount you contribute and generally it is from the highest marginal tax rate. This equates to an effective tax rate of This is due to the progressive tax system we have, you have to determine what tax bracket the money is coming from and the effective tax rate it is being distributed at. Now I understand you believe you will continue to make more money as you grow older.
However the same principle still applies. But your distribution, assuming no other sources of income, will be taxed at an effective More into a Roth account when you make less money and then more in the k as your salary grows.
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The cutoff point is personal to each individual, depending on how much passive income they will generate in retirement, how much they want withdraw annually from retirement among other factors. For people who live in a high-income-tax state and plan to retire to a zero-income-tax state, a traditional k will allow them to defer those high state taxes FOREVER. For such people, a Roth account may be unwise. Actually, your examples shown would be correct, right? So the balance shown in the Roth k column is all his. The balance shown in the Traditional k column is before he gets taxed on it because that is money that his employer put in.
So he is only on the hook for the Traditional k column and off the hook for the Roth k column.
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A number of good points made here. Effective tax rate is important but remember the k is not likely the only income source. You may double, triple or more your contributions, all of which is tax free upon withdrawal from the Roth. Taxes were only paid on the original contributions. Your email address will not be published.
K. A. Lindow, CPA, P.C. CPA Firm Firm, Phoenix, AZ.
How a Roth k Works vs. Should I Contribute to a Roth k? Taxes Make The Difference So which is better? Comments For my situation the Roth worked out well too. Thanks for stopping by. Please Address: Where in your Roth balance are you paying income taxes? What are you talking about?