Choose the Right Retirement Accounts in 3 Simple Steps

If you’re confused by all the tax-advantaged retirement account options you can choose from, it’s time to get clarity and use them to build more wealth for the future. Laura walks you through 3 simple steps to choose the right retirement accounts for your situation. 

Laura Adams, MBA
11-minute read
Episode #541

Step #3: Choose your retirement tax types.

After choosing one or more types of retirement plans to fund, a key decision will be which tax type to choose: traditional, Roth, or both. Most retirement accounts come with a Roth option and you can split contributions to both types, as long as you don’t exceed the annual contribution limit.

Most retirement accounts come with a Roth option and you can split contributions to both types, as long as you don’t exceed the annual contribution limit.

For example, if you’re qualified for a Roth IRA and are under age 50, you could contribute $2,000 to a traditional IRA and $3,500 to a Roth IRA in the same year—but not $5,500 to both.

The same concept applies when you have a workplace plan with a Roth option. You could contribute $10,000 to a traditional 401k and $8,500 to a Roth 401k in the same year—but not $18,500 to both.

So, how do you know if a traditional, Roth, or a combination of tax types is right for you? Well, start by answering these three questions:

1. Is my income tax rate going to be higher or lower in retirement?

With any traditional retirement plan, you get a break by delaying taxes until you take withdrawals in retirement. You end up paying tax on your original contributions and their investment growth.

Roth accounts work the exact opposite way. With a Roth, you pay tax upfront on contributions, and then pay zero tax on withdrawals in retirement. You skip paying tax on all the investment earnings, which can be a massive savings.

To pay as little tax as possible, consider if your income tax rate could be lower now relative to when you retire. If you believe that you’ll be in the same or a higher tax bracket in retirement, choosing a Roth is best.

The idea is that paying tax on Roth contributions upfront at a lower rate saves you money. Here are some situations where your tax rate could be higher in retirement than it is today:

  • You’re currently in an entry-level job and expect to be earning more in the future. 
  • You expect to receive an inheritance in the future. 
  • You have a hunch that income tax rates for all Americans will rise in the future.

But if you’re further along in your career and earn more now than you believe you will in retirement, you’re generally better off with a traditional IRA or traditional plan at work. When you take withdrawals in retirement, you’ll end up paying less tax if you have a lower tax rate than you do today.  

Problem is, none of us really know what will happen in the future, especially if you’ve got a long way to go until retirement. So, if you’re not sure about your tax rates, another tip is to diversify by having both traditional and Roth accounts. That way you’ll have taxable and non-taxable money to spend in retirement.

For instance, you could put half your contributions in a traditional 401k and half in a Roth 401k. Or you might have a Roth retirement plan at work and a traditional IRA on your own.

See also: Which Is Best: A Roth or Traditional Retirement Account?

2. When do I prefer to pay income tax?

While most people would prefer to never pay taxes, when it comes to your retirement nest egg, at least you have control over when you pay them.

If you have a heavy tax burden from high earned or investment income, making contributions to a traditional retirement account is a smart way to reduce what you owe. You’ll get a tax deduction in the year you make traditional retirement contributions, which cuts your current tax bill.

If you have a heavy tax burden from high earned or investment income, making contributions to a traditional retirement account is a smart way to reduce what you owe.

Roth contributions are never tax deductible, so they don’t help your current tax situation. But, as I mentioned, the beauty of a Roth is that withdrawals in retirement are completely tax free. If your account mushrooms in value over many years, you get to keep every penny in retirement.

So, your current and future tax situation plays a big role in whether you should use a traditional or Roth retirement account. But don’t get too bogged down in the decision. You can always start or stop contributions at any time if your financial situation changes.

3. Do I want penalty-free access to the account before retirement?

Tapping a retirement account before you reach the official retirement age of 59½ typically comes with having to pay income tax, plus a 10% early withdrawal penalty. While you might think it’s unfair to have your wrist slapped, financially speaking, to access your own money, the purpose is to make sure you have funds to spend in retirement, not before!

However, there are some exceptions. Roth accounts offer more flexibility than traditional ones when it comes to taking early withdrawals. That’s because you must pay tax upfront and you control the account as an individual. A Roth IRA allows you to withdraw your original contributions (but not their earnings) at any time and for any reason.

While I recommend leaving retirement accounts untouched until you retire, having a Roth IRA does give you the most flexibility to tap your funds ahead of retirement. So, if you’ve got a long way to go and are worried that you might need to spend some of your retirement savings, choose a Roth IRA, if you’re eligible.

I received a question from Kathryn M. who’s got a retirement account dilemma. She says, “I contribute $18,000 per year to a traditional retirement plan at work, but we also have a Roth option. I don’t have an IRA, but I’m leaning toward choosing a Roth IRA since I already have a traditional account at work. But my boyfriend and I expect to get married in a couple of years and our joint income will likely be too high to qualify for a Roth IRA. So, should I open a traditional IRA instead and change my contributions at work to the Roth option?”

Thanks for your note Kathryn and congratulations on doing such a great job earning and saving! I’m a big fan of using a Roth at work because they don’t come with income limits and allow you to make relatively high annual contributions. So, unless you really need the tax deduction of a traditional plan, switching over to the Roth at work makes sense.

Again, unless you need the tax deduction of a traditional IRA, I’d open a Roth IRA while you’re eligible. And if your joint income makes you ineligible down the road, you can simply let it ride and contribute to a traditional IRA instead.

We’ve covered some of the biggest considerations for choosing retirement accounts, but there’s no right or wrong answer. If you’re still not sure, having a combination of tax-deferred and tax-free accounts covers all the bases.

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About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.