Roth Contributions And Why You Should Make Them

If you have earned any income this year then you are eligible to open an IRA. Check out IRA basics for more on those. You also may be fortunate enough to work for a company that has set you up with a 401(k) plan. Now more than ever you should make Roth style contributions where possible.

What Is “Roth?”

Whether talking about Roth IRAs or Roth contributions to a 401(k), these contributions are made on a post tax basis and have different benefits from the traditional (pre-tax) contributions.

Why Roth?

A lot of times you will hear advisers simplify the choice between traditional and Roth down to one question: “do you think your taxes will be higher or lower than where they are now once you retire?” If you believe that you will be paying more than your current tax bracket when you retire then Roth would be recommended, and if you believe you will be paying less then traditional is recommended.

Right now, if you are young, you are probably paying some of the lowest taxes that you will pay in your lifetime. Not only is your income much lower than it will likely be in retirement (at least I hope that will be the case), but even if your income was unchanged I have my doubts about the ability of the United States to keep taxes as low as they are now in the face of the looming national debt.

Easier Access To Your Money

Roth style contributions also have a convenience factor not found with traditional 401(k)s or IRAs. Any contributions made on a Roth basis can be withdrawn at any time tax and penalty free. Because you have already paid taxes on these dollars it is a much more simple process to get to them if you truly need them for something. Withdrawing from traditional style 401(k)s or IRAs can be arduous and has tax consequences. Nobody can know what sort of opportunities will present themselves in life and the idea of traditional contributions being tied up until age 59.5 is not an idea I am fond of.

Tax Free Gains

While gains in a traditional IRA or 401(k) grow tax free, they are taxed at the time of withdrawal. Even worse, they are taxed as income. This may be my biggest qualm with the traditional structure. This structure means that you will more than likely pay more taxes on your gains than you would on gains made by just buying and holding assets in a standard brokerage account. The highest long-term capital gains tax is currently 20% where as the highest current income tax is now 37%. This means that if you are a high-earner you may pay almost double the tax on those gains than you would in a standard brokerage account.

Of course, if you pay taxes up front and put your money in under the Roth structure your gains will not be taxed at all.

Making The Switch

If you already opened a traditional IRA, switching is not too difficult. You will just need to convert it to a Roth IRA which will require paying taxes on the balance of the traditional IRA. Honestly, a pretty great time to do so since just a year ago you would have had to pay more tax on that money under the old tax structure.

For company 401(k)s you will need to check and see if Roth contributions are offered. For my plan it was as simple as checking a box to select Roth style contributions.

Hopefully this gives you a better understanding of your contribution options when it comes to tax-advantaged retirement accounts. For most young people Roth should be the easy choice.

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