Find out how traditional and Roth retirement accounts help you pay less tax and accumulate more wealth for retirement.
How Tax-Free Withdrawals from Retirement Accounts Save Money
In addition to traditional accounts, there’s another type of retirement account called a Roth. These flip-flop taxation from a traditional account because contributions to a Roth are not tax-deductible, which means you must pay tax on them upfront.
A Roth allows you to avoid paying one penny of tax on growth in the account that may have accumulated over decades.
For instance, if you earn $50,000 and contribute $5,000 to a Roth IRA or Roth 401(k), you must pay tax on $50,000 that year. There’s no immediate tax benefit for Roth contributions.
However, the great feature of a Roth is that future withdrawals that you make after age 59½ are completely tax-free (unlike with a traditional account). A Roth allows you to avoid paying one penny of tax on growth in the account that may have accumulated over decades.
You can even withdraw your original contributions tax-free before reaching age 59½, if you’ve owned a Roth account for at least 5 years. But withdrawing any amount of earnings from a Roth IRA or workplace plan triggers a 10% early withdrawal penalty.
Let’s say you put $5,000 a year into a Roth IRA for 30 years, which is a total of $150,000 in contributions. If that amount mushrooms to a value of $450,000, you’d avoid tax on the difference, or $300,000 of earnings. Depending on your situation, that might give you a tax savings of $60,000!
As long as your money stays in a traditional or Roth retirement account, you won’t pay any tax on investment earnings. They get reinvested and compound year after year without any federal or state tax bill.
As I previously mentioned, you’ll never get a tax bill from a Roth account when you withdraw money in retirement, but you will for traditional accounts.
Do States Tax Retirement Accounts Differently?
A listener named Paul asks:
"I have traditional and Roth retirement accounts and have been contributing to them in Texas, where there is no state income tax. If I decide to retire to a different state that does have income tax, would I have to pay it on my retirement distributions?"
The good news is that no matter where you live, you won’t have to pay any federal or state tax on Roth distributions. However your traditional account withdrawals will be subject to both federal and state income tax depending on where you live during retirement.
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